Sorry – no posting for a while…

I broke my collarbone in a bicycle crash.

Fannie and Freddie series to be continued…

If we want to change the world – we can… we just have to think we can. Kaupthinking was beyond thinking…

I used to look at awed wonder at the insanity of Icelandic banks – but I never heard of this advert (for Kaupthing Bank) until after the collapse and the destruction of Iceland’s economy and I saw it for the first time only recently.  It spreads virally amongst finance types – but I think it will be new to my Talking Points Memo readers…

 

 

Kaupthing was – I believe – the worst bank in the whole crisis… and has since been shown to be corrupt.  But a good proportion of the employees really believed that they were doing something worthwhile which says more about cults than banking (except in as much as modern financial practice is littered with cult-followers).

Hat Tip to Felix Salmon, thence to Ultimi Barbarorum, but really to Lara Hanna Einarsdottir – who writes in Icelandic but who once left some (deservedly nasty) comments on my blog…

Finally – I note with fear that the bank doubled in size in a year – every year for 8 years. I considered shorting Kaupthing several times – but did not (in part because of the cost and difficulty of borrowing the shares).   Banks like Kaupthing might be insane criminal organisations – but they were also impossible to short because they might stay solvent longer than you…  Three doublings and your short has become very painful – even if you are paid in the end.  Add to that a 25 percentage point borrow cost for the shares and there was little chance of making money unless you shorted right at the end.  Oh, and your profit (if any) was realised in Icelandic Krona – and they turned out to be worth much less than you would have hoped.  It is hard to make money of this stuff – even when the end-outcome is obvious.

Modelling Fannie Mae and Freddie Mac – Part VIII

In Part VII I did an “idiot check” on my credit loss numbers. They appear pretty robust. This post does an idiot check on the pre-tax, pre-provision profit estimate. Here I am less confident.

The massive rise in GSE pre-tax, pre-provision profits is one driving factor behind my assertion that the GSEs can recapitalise. In the Freddie Mac 10Q from the first quarter was this (often quoted) and profoundly bearish line.

Our annual dividend obligation, based on that liquidation preference, will be in excess of our reported annual net income in nine of the ten prior fiscal years. If continued to be paid in cash, this substantial dividend obligation, combined with potentially substantial commitment fees payable to Treasury starting in 2010 (the amounts of which have not yet been determined), will have an adverse impact on our future financial position and net worth, and will contribute to increasingly negative cash flows in future periods.

This line – or variants on this line are repeated multiple times in the recent 10Q.

This is a blunt statement that Freddie could never repay the government because it owed the government $5.2 billion per annum and that was more than the earnings in almost every prior year.

There is a little that is disingenuous about this statement – possibly deliberately. The statement compares the obligations to the Treasury to the post-tax, post provision income for the past decade. In most years the pre-tax, pre-provision income of Freddie was in excess of $5.2 billion (which would have allowed some repayment). But far more to the point – the current pre-tax, pre-provision income is in excess of $15 billion. After write-backs they dealt with over 8 billion of the 50 odd billion outstanding in one quarter in Q2 – but they are not permitted to make the actual repayment (more on that in a later post).

Here is a cut-down version of the profit and loss account from the last quarter:

Revenues – net of mark-to-market swings – are up from 2.3 billion to 4.4 billion. Administrative expenses are down slightly. Pre tax, pre provision profits are probably running above $4 billion per quarter.

But that of course nails down the problem. The situation is so rosy for the preferred (and survivable for even the common stock) precisely because the pre-tax, pre-provision income is so high. If the high pre-tax, pre-provision earnings go away so does the taxpayers’ chance of getting repaid on their Fannie and Freddie bailout money – and – for that matter – so do the preferred securities that we at Bronte Capital have so carefully (and cheaply) accumulated.

First lets see what the margin is for

Fannie and Freddie make their margin two ways -

1. By charging guarantee fees for mortgages that it guarantees, and

2. By holding mortgages and earning a spread.

The guarantee fee margins were a fifth of a percent of outstanding balances or less for as long as I remember. I always thought that those margins were insanely low – and indeed the very low margins for insuring credit risk is (in my opinion) the main reason why Fannie and Freddie were in long-term-trouble. Banking systems without enough profitability cannot survive bad times. I have blogged about that extensively – see here for a (controversial) example. Those guarantee fees are going up but by no means enough. It would not be unreasonable to charge 0.4 percent however under Conservatorship and even with an absence of competition fees have not risen to that level. In the absence of competition Fannie and Freddie should be able to raise guarantee fees sharply. They should too – otherwise the fees are not reflective of risk. However the fees have not risen by quite that much – and the only explanation I have is political interference. (Again you will need to wait for another post.)

However with a guarantee book of less than 3 trillion dollars guarantee fees – whilst important – are not the way in which this company recapitalises. Guarantee income was about 700 million last quarter. Not small change to anyone but Fannie and Freddie – but not enough to produce the profit stream necessary to cover forthcoming defaults and to repay the government. My guess is that the guarantee fees rise over time but only if the regulator allows them to rise.

The driver of high-pre-tax, pre-provision profitability is high interest rate spreads. They are high because of lack of competition. Interest margins are rising pretty well everywhere in banking – but not as intensely as at the GSEs. There is roughly 900 billion on the book. Making 1.2 percent on that – which does not seem unreasonable but is much higher than the traditional Fannie or Freddie margin will get you to solvency – however solvency for the GSEs emerges after say 7-8 years under this normalised income scenario. The current spreads are way higher than normal – unsustainably high. Those unsustainably high spreads might lead to very rapid recapitalisation.

Now obviously some of the excess spread is due to the steep yield curve. That will go away – but if the company were solely playing the yield curve the spread would be much higher than it currently is. Last I looked the spread between floating rate Fannie obligations and wholesale guaranteed mortgages was several hundred basis points.

The income is also inflated at the moment because charges that were taken as the companies went into conservatorship is being reversed through the net interest income line. I wish I knew how to quantify this. (I described this issue in Part II.)

Unfortunately at some point the trend in income will be down. When income goes down so does the ability to repay. Close observation of the margin between GSE treasuries, GSE debt and wholesale guaranteed mortgages indicates that the margin peaked a couple of weeks ago. Two-weeks of data is not convincing – but my guess is that pre-tax, pre-provision operating income will be about flat (maybe slightly down) in the third quarter and will trend down (perhaps slowly) from there.

Risk of being forced to shrink

The first and obvious risk is that the GSEs will simply – by government fiat – not be allowed to earn the spread. When the GSEs were put into conservatorship they were obliged to shrink their balance sheet fairly rapidly after the first two years. If Fannie or Freddie shrink their balance sheet they will shrink their spread income. If this is done rapidly enough they will never repay government. The requirement to shrink the balance sheet has been reduced dramatically – and is unlikely to be enforced in the absence of a robust private sector mortgage market. Obviously the reality (that these companies are by far the dominant mortgage providers at the moment) has sunk in. Shrinking them now would blow up a good part of the recovery. But I suspect that some politicians will want them to shrink. (Others will have different feelings – again the subject of a later post.)

When the Republicans (for example Spencer Bachus) want to force the issue on Fannie and Freddie right now, that is what they are suggesting. If you allow them to shrink they inevitably die – and they cost government when they do so. Indeed it appears that the Republican agenda was always to destroy these companies. I will discuss the politics in a later post. The politics is interesting – as in the Chinese curse. We live in interesting times…

The second risk to the GSE income is that somehow competition comes back into the mortgage market. I suspect that is a few years away. We only need to last a few years for the securities to be visibly money-good. Nonetheless I can’t imagine the spreads remaining this wide indefinitely.

The third risk is that Fannie or Freddie massively stuff up their interest rate hedging and fail to adequately hedge the mortgage refinance risk or the short term interest rate risk on their book. Fannie had a (relatively) minor hedging problem I think in 2002 in which they were short duration and interest rates moved against them by about 10 bps in one day. My count at the time was that they lost $8 billion. They could do that again. I have no way of estimating the chance of that – but I am relatively comfortable with the interest rate risk in the book at the moment. [Losing $8 billion in a day is relatively minor only when compared to the losses that Fannie has had on the credit cycle. Interest rate risk is part of these businesses.]

The commitment fee

At the end of this year the government has the right to charge Fannie and Freddie a commitment fee (mentioned in the quote above). The size of this fee has not been determined. This fee does not change the end loss to taxpayers but it may change the value of Fannie and Freddie’s preferred and common stock. An excessive fee could lead to a fifth amendment complaint by preference shareholders. However it is a real risk to this thesis.

Summary

I am a preferred shareholder and – as a shareholder in anything – nearly always worried about risk. But if I had to tell you what keeps me awake at night it is essentially political decisions crimping Fannie and Freddie’s ability to earn revenue. In particular they may not – by government fiat – be allowed to charge adequate guarantee fees. They may – by government fiat – have to shrink their book very radically thereby reducing spread income. They may – also by government fiat – be kept perpetually insolvent by way of the forthcoming commitment fee.

John

Post script

A note… I was a little more sloppy about the costs at Fannie and Freddie in Part VI than I should have been. Some accurate criticisms have been received as to how I broke up cost items. However I note that costs are seldom more than 12-15 percent of revenue at the GSEs. The GSEs are large wholesale institutions – buying bulk mortgages and doing finance in bulk. Costs do not matter much. What matters is revenue (this post) and credit losses (last post). When it comes to the 10Qs I have always read the cost section relatively fast as it is relatively unimportant.

The real risks to my thesis are on the revenue line and in the credit cost estimates.

Modelling Fannie Mae and Freddie Mac – Part VII

In Part VI of this series I came to the (non-consensus) conclusion that both Fannie and Freddie were long-term solvent and that the cost to the government of their conservatorship would be zero.  I also suggested that the common stock had value and that the (non-cumulative) preferred shares (currently trading at 4c to 6c on the dollar) would one day receive par. 

There are model sensitivities and economic sensitivities to this conclusion.  In this post I want to (begin to) explore how robust those conclusions starting with the model in Part IV.  I am conducting an “idiot check”.  In the next two posts I will do idiot checks on Parts V and Part II. 

I apologise in advance as these three posts will look a little disjointed compared to Parts I to VI.  In this post I am using all sorts of anecdotal or practical data to test my hypotheses… this is a practical - not a theoretical exercise – and it is as a result messy.

Background

In Part IV I built a model which predicted future credit losses for Freddie (and told you I had done so for Fannie).  We know that there are huge credit losses coming at Fannie and Freddie as delinquency is rising, house prices are awful and default is becoming more commonplace.  My model allows for huge losses.  The main question is whether the losses allowed for are quite huge enough.  The bears (and there are many) seem to assert losses considerably larger than I am projecting.

Well lets start with one of my favourite charts of the traditional mortgage guarantee business.  Again I do this only for Freddie Mac – leaving the reader to do it for Fannie if they want.

In this graph we have $1.907 billion in charge offs during the last quarter and 1.104 billion in the quarter before.  The charge-offs were effected by the foreclosure moratorium which would have meant charge offs were understated in Q1 and overstated in Q2.  Lets call it an average of $1.5 billion per quarter.

At the end of the 2nd quarter there were 25.2 billion in reserves.  I calculated in Part IV that an additional $12.5 billion would need to be provided for over the out-years.  We have thus built 35.7 billion of loss reserves (current reserves and reserves to be taken) into our model.  The key sensitivity question is: is this enough?

Well – if the loss rate does not get any worse then $35.7 billion at $1.5 billion per quarter would last 23.8 quarters or almost 6 years.   I can be fairly confident that if realised loss rates do not rise then model reserves are adequate – as the alternative requires A substantial numbers of people who obtained their mortgage in 2006 to remain current until 2014 and then default.  That is possible if the economy is really sour in 2014 – but it is not an obvious or expected outcome. 

More realistically I am modelling realised losses rising for some time before falling.  Foreclosure stats are rising in aggregate – albeit rising at a slower rate.  If realised losses were to double we could last three years and still be reserve adequate.  That is roughly what the model would imply.  If realised losses triple and remain at that rate then (unfortunately) my 35.7 billion in losses still to come will wind up being an underestimate.  So in a sense – what is required is some comfort that the realised loss rates – particularly in the nasty 2006 and 2007 vintages are unlikely to much more than double from here.

Test 1 – what is happening at on the ground in California

California is the worst state for losses for both Fannie Mae and Freddie Mac.  Some states (particularly Arizona and Nevada) have higher losses as a percentage of loans outstanding.  Some states (particularly Michigan) have higher severity – with many houses recovering less than $2000 on foreclosure.  But California is a massive state with high house prices and high losses.  Arizona and Nevada are simply not large enough to make my estimates wrong.  California is.

Fortunately California has very good data on defaults, notices of trustee sales and recoveries at trustee auction courtesy of Foreclosure Radar.  Paul Kedrosky has pointed out that we have reached the “new normal” in California – a stabilisation of foreclosure processes at high levels. 

 

The point is that the worst state has stabilised.  This tends to indicate that the defaults are not even going to double from here – let alone triple.  On this piece of evidence my default loss estimates are over-stated and Fannie and Freddie will return to full solvency more rapidly than I previously anticipated.  Moreover – adding to the robustness – the proportion of realised losses happening in the “bubble states” (California, Nevada, Arizona, Florida) has been rising by quarter – not falling – so it is reasonable to assume that as-go-the-bubble-states-goes-the-whole-book.

Test 2 – early stage delinquencies

Early stage delinquency (particularly 30-60 day buckets) is the best leading indicator in delinquency data.  90 plus delinquent loans will continue to rise well after the economy or credit cycle has turned because bad loans accumulate – especially when selling foreclosed property is hard.  By contrast loans going through the 30-60 day bucket give you an idea of the flow rate into problem loans.  When the 30-60 day delinquency improves you know the credit problems are ameliorating (even though the 90 day buckets are getting worse).  One of those hopeful leading indicators is that in many categories of loan I look at the 30-60 day buckets are improving – and usually improving more than seasonal factors indicate.  [That bucket is seasonally difficult in February when the Christmas bills come due and easier in summer because there is more overtime or temporary work about…  Incidentally 30-60 day buckets are getting better in some credit card books as well.] 

Fannie and Freddie (unfortunately) do not give early stage delinquency data (I believe because the loan servicers report the data inconsistently).  However the office of thrift supervision has recently conducted a survey.  You will find this chart – and much more data like it on the OTS site.

 

Again this indicates that is unlikely the charge-off will even double.  It is unlikely to more-than-double – and again it seems my loss estimate is too high.

Estimated defaults versus amount in mortgage pool

The model presented in Part IV estimated losses for each year of business.  Here is the table again:

 

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

 

Now we estimate that (as of year end 2008) there were 13.2 billion of losses (and 21.9 billion in defaults) left to come in the 2006 year of business.

The Freddie Mac credit supplement gives us other data about the credit in that year of business. 

 

 

There is in the 2006 vintage only 236 billion of unpaid principal balance left – and that number is falling quite fast.  (The rest has refinanced, defaulted already or been repaid.)  We have built into our model a 9.28% default rate from here.  Given that the seriously delinquent loans are only 6.34 percent that seems a little harsh – all seriously delinquent loans need to default and then there needs to be another serious round of new delinquencies.  Given that most delinquencies cure (even in times like this) because people with a default notification often try hard to pay rather than have their house foreclosed on – the required foreclosures being about 1.5 times the current delinquency does appear to be a high estimate. 

I guess – and people will say this – that people could walk-away with loans going from current to default very rapidly.  34 percent of the loans have a current loan to value ratio above 100 percent and almost all of those loans are current.  My only counter – and I know this is a weakness – is that whilst it may be in their interest to walk-away from their mortgage they are not doing so.  It could be that they are unaware that their home loan is underwater (and there is some evidence that Americans know house prices have fallen but delude themselves about their own house).  It could be that they just have good credit , the house is not far underwater and they want to pay.  It could be that they have scattered daddy’s ashes in the backyard and walking away is unthinkable.  More likely – with a 90% LTV loan on a 200 thousand dollar house you might not walk away even though the mortgage is underwater because the mortgage payments are lower than the alternative rent payments.  Whatever – they are not currently defaulting.  That is all I can say on this data.  If people have data that suggests that this will change soon I am interested.  I see no data in aggregate proving that point although there has been some data about the extent to which people are deluded as to the value of their own home and that their level of delusion is economic-conditions correlated.

The shift in housing problems

The housing market crash began with low end housing.  In most markets jumbo mortgages retained fairly good credit until recently – though there is considerable evidence that upmarket housing is experiencing trouble now.  There is also considerable evidence – much of it anecdotal – that lower-end housing prices have stabilised.  [Certainly in most markets it is considerably cheaper to buy low-end housing and make mortgage payments than it is to rent.]  This is generally supportive of my thesis as the critical 2006 and 2007 books at Fannie and Freddie contain no mortgages above $330 thousand.

An observation about second derivatives

As indicated in Part VI we at Bronte purchased Fannie and Freddie preferred stock fairly aggressively at below 2 cents in the dollar.  It was March when we first started doing that – and the world looked like a sour place.  The idea that Fannie and Freddie might actually be solvent seemed unthinkable – but we were busy thinking it. 

At the time everything was getting worse at an increasing rate.  The expression is “free-fall” – where you simply accelerate towards some immovable hard object.

The modelling did not feel very robust and the reason it did not feel robust was that all the leading indicators were getting worse.  In the curves in Part IV the 2006 and the 2007 curves were accelerating away from 2000 curve.  They did not look bounded at any multiple of the 2000 curve that I could get comfortable with.  I knew defaults would continue to get worse for a while because there was a big build-up in the delinquency buckets and delinquency is a precursor to default.

What would make me confident (and believe me I was not confident) was a deceleration in the rate things were getting worse.  I was interested in the “second derivative”.  For a while (up to about April) the second derivatives all looked good.  Briefly the second derivative of total delinquency looked bad (as reported in Fannie’s monthly data) and that really rattled me.  I posted that here.  That data-point was – it turns out – an exception to the general trend.  Only recently there have been a few bad data points (for instance the recently reported rise in early-stage delinquencies at Capital One Financial suggesting a “W shaped” recovery).

With anything that looks like a W shaped recovery this model could be wrong.  For instance we could have another big leg down in either property prices or the economy.  The data does not generally support that second leg down but that might change.  The Capital One numbers have given me pause. 

But more generally we are making predictions which are ultimately just guesses.  I hope I have convinced you that they are educated and rational guesses.  But guesses nonetheless.

The main objection I have received so far – is about loans with risk layered terms that Fannie and Freddie have in their traditional book

There have been a few objections (mostly in email) that suggest that I assume away much of the dross in the conventional Fannie and Freddie books.  Here is one email from “bob”, a mortgage market professional.

Well reasoned, but... there is a presumption in the marketplace that Fannie & Freddie's book of traditional business is solid stuff.  One has to really question that.  What about the 100 LTV loans made to borrowers with 570 credit scores and 67 DTI's?  What of the 90 & 95 LTV Interest Only loans made to flippers?  What of the 90 LTV Stated Income loans (many made to flippers)?  What about the LTV's being based on stretched and hyped appraisals?  What about the mortgage company "art departments" which cranked out custom W-2's and paystubs to document loan files with?  What about all of the high LTV loans made to people with 50% DTI's and no money in their checking accounts?  And how do you square it all with a huge and growing percentage of mortgaged homeowners who are underwater- far too many of whom are (or soon will be) unemployed or making substantially less than what they were?  Then to top it off, one can only shake their head when it comes to REO disposition practices.  Bottom line, I think any model must attack the assumption that the GSE's book of traditional business is solid stuff.  Unfortunately, Fannie & Freddie were aggressive hedge funds operated to generate executive bonuses, and under the supervision of a defanged regulator.  I'm afraid that when the tide finally goes out, it will not be a pretty sight.  [Emphasis added…]

I will deal with this in a modelling context – but then also in specifics.  My model – which just assumes that defaults in the 2006 and 2007 vintages follow a curve with a similar shape to the 2000 vintage – makes no assumptions whatsoever about the content of the book.  It just looks at the 2006 book, notes that it is currently defaulting at 2.8 times the rate of the 2000 book, that the difference between the 2006 book and the 2000 book is expanding – and hence the end default may be 4.5 times the 2000 book.  Essentially though I am assuming because things are getting worse they are going to continue to get worse. 

One thing however is generally true about the mortgage market – which is the very bad loans default fast in a crisis – and then the defaults from that pool ease up, whereas good loans default slowly and defaults do not ease up for a long time.  That is consistent with simple models of human behaviour.  If you have a 100LTV loan which you purchased on a property you intended to flip in the Inland Empire then you have probably walked already.  Why?  Because the incentive to keep making the payments on a cash-flow negative property is very low.  You will probably pocket three months rent whilst the bank actually gets around to foreclosing on you – but your motivation to pay is low.

If – by contrast – you are a regular mom-and-pop buyer who purchased a home to live in and put down even 10% (which you saved by dint of hard work) then your incentive to walk-away is low.  You have emotional investment in the property even if your financial investment is wiped out.  The incentive to pay (because you do not want to be forced to move) is high.  Moreover there is a real tendency to self-delusion as to the value of the property and self delusion lowers default rates.

If a book consists of flippers and 100LTV loans then the defaults will be front loaded.  My model assumes that the defaults are rear-loaded.  The more of the drossy loans described by Bob the more the defaults will be front-loaded and the more my loss estimate is thus an overestimate.  If Bob were right I would be more comfortable with my estimates – not less comfortable.

Unfortunately – despite the protestations of Bob (and others) there are actually relatively few truly risk layered loans in the traditional books of Fannie and Freddie.  For that I need to explain risk layering.  Consider the following three loans:

Loan A is made to a customer with terrible credit (a FICO of 580 reflecting past defaults).  However the customer has clearly reformed and they now hold a stable job which you have verified.  They have saved up $25 thousand and they are buying a very low-end property (say $130 thousand) in a non-bubble state.  This is a low FICO loan or a loan to a subprime borrower – but with otherwise good characteristics.

Loan B is made to someone with pristine credit and a stable income.  You have verified the income is more than adequate to serve the loan.  The family has emotion invested in the house as they have purchased near the school in which they enrolled their children.  However the down-payment is only 3 percent because the equity that they had saved had been blown because the family had recently had medical problems.  This is a high loan to valuation loan - but with otherwise good characteristics.

Loan C is made to a customer with terrible credit (580 FICO reflecting past defaults).  The customer has a stable income which you have verified – but they are purchasing a 250 thousand home with only a 3 percent down-payment.  There is little evidence in their past behaviour that that they are capable of saving money for a rainy day.  This is a risk layered loan in that it has two major risk factors – a subprime borrower and a high loan to valuation ratio.

With these three Loan A and B are probably both good under almost all circumstances.  The first borrower shows little record of past willingness to pay a loan – but in this case they have a real incentive to pay and the ability to pay.  They probably will pay.  The second borrower shows a very good willingness to pay and the ability to pay – but their incentive to pay (being the remaining equity in their home) is low.  Nonetheless they have emotional commitment to the community and foreclosure is a difficult option.  Loan C is terrible.  You have the bad borrower and they lack incentive to pay.

The collapse in underwriting standards that occurred in America was due to risk layering.  Two risk factors is many times more risky than one risk factor.  Fannie publishes a table of how many of their loans have various risk factors. 

 

From this table you can estimate how many of the loans have multiple risk factors.  If you add up the special risk factors you get $1,112 million.  However the actual dollar value of loans with a risk factor is 878 million and those loans are 72 percent of losses thus far. 

The numbers also suggest that at most $233 million have more than one risk factor.  That is less than 9 percent of Fannie’s book has risk layering – but my guess is that those small number of loans will be about 40 percent of losses.

The point is that the proportion of losses from risk factor loans is now declining (consistent with the argument above).  It is loans without risk factors (the heart of the traditional Fannie and Freddie business) which is going to show increasing losses.   

Fannie gives some data on loans with two risk factors – separately breaking out loans with a FICO below 620 (which means the borrowers are truly subprime) and with a LTV above 90% at origination.  There are only 25.4 billion of these – 0.9 percent of the book.  However these loans represent 5.7 percent of all losses – they are more than six times as loss intensive.  Note that the proportion of losses coming from this pool is falling – probably because the loans have a tendency to default fast – you get loss burnout.  The subprime loan pool – 0.3 percent of books but 1.1 percent of losses has had even faster loss burnout.

Anyway – contra to Bob’s email my estimate is more likely to be an underestimate precisely because there is not that much risk layering in Fannie’s book.  If the losses burn out fast then they are not likely to rise far from current loss levels.  If the losses burn out slow (which is what would happen with lower-risk mortgages) then loan losses could rise for a long time as families slowly burn through their financial resources trying to keep current in their mortgage.

Sensitivity as to the income line

I am fairly confident about my estimate of credit losses at Fannie and Freddie.   Those are manageable – and the end loss to taxpayers is very unlikely to be large.  I am much less confident that the income line (which has expanded greatly) can remain so generous.  And for the losses to taxpayers to be zero I need the companies to be able to earn their way out of their current predicament.  I need the current large operating income to continue – or at least not to drop suddenly.

The sustainability of the operating income is the subject of the next post.

Health Care Reform and single payer – an Australian perspective

I write a financial blog which is republished on the largely political Talking Points Memo.  I thought I better write something for both my audiences sometime – so I am jotting down my thoughts – from an Australian perspective – on single-payer health care reform.  After all the ongoing Fannie and Freddie series has a limited audience.  

Warning – I am putting the positives of the Australian system up front.  There are some very substantial losers too – those are discussed at the end of the post.

Much of what I write is a 12 year old perspective (and the data I have in my head is that age) because 12 years ago I worked at the Australian Treasury and followed the numbers more closely.  Moreover I am normally a bank analyst – and am stepping (way) out of my area of expertise.  There are bound to be some errors and the lack of (recent) quantification I would not normally tolerate.  With that caveat – here goes.

Australia has a hybrid private-socialised medical system.

For reference I think the Australian system is superior to anything in Canada or the USA. I am less familiar with the European models. The Australian system is better thought through and will work better than anything Obama is proposing. However Australia had weaker incumbents than America, some advantages over America (which I will get to) and has had 20 years tweaking the system in lots of ways to make it work better.  These systems require a lot of tweaking and if Obama implements something worthwhile the next twenty years will be spent reforming it.

The way I think about it is that the US has a fundamentally broken market system. We know it is fundamentally broken because it costs a lot and produces fairly poor outcomes in aggregate.  Stories about failure of insurance companies to honour their promises are legion.  Many people have conditions that make them uninsurable. America spends a greater proportion of GDP on health (and greater dollars) for worse outcomes almost no matter how you measure it. If you do not agree with that statement you simply refuse to acknowledge clear facts on the ground. Health coverage is one of the major issues for middle America and many are unsatisfied.  By contrast political and general population satisfaction with the Australian system is high and has by-and-large been rising.

Australia has a system whereby primary medical care (general practice doctors), much specialist health care (for example a cardiologist) and almost all important pharmaceuticals are covered by the government but with a copayment by patient. Most the copayments are large enough to be annoying (the service is not free) but do not cover anything like the costs. The copayments differ sometimes due to your income status. For instance most people have a copayment for pharmaceuticals of about $20 – but for (low income) pensioners the copayment is $5.

There are also government run public hospitals – run by State Governments – but where the funding almost entirely ultimately comes from the Federal Government through transfer payments to the States. These hospitals have a public emergency room which rations via triage. [Turn up with a sprained ankle and you might wait twelve hours, turn up with chest pains and the waters part for you.]

After admission to the public hospital [either through a consulting specialist or through the emergency room] you will get a shared ward and no doctor of your own choice – but a very high standard of care by global standards. Non-urgent procedures are queue rationed – and the queue is long and annoying and was once the main issue at State Elections. But the treatments eventually happen. Queue rationed conditions can involve some pain and hence there is real annoyance at the queues. [Gall stone removal for instance is queue rationed. They are painful until removed.] 

You can be admitted to a private hospital in the same way as the public hospital. The admission is either from a consulting specialist or through the emergency room at the public hospital.  At a private hospital you have your choice of doctor, often a private room, sometimes slightly better food and distinctly less pressure to leave until you are recuperated. Most importantly, private hospitals are not highly queue rationed.  When my wife needed knee surgery after a skiing accident the wait was two weeks at a public hospital or alternatively the next day the doctor was in surgery at the private hospital.  That was an easy choice.

To go to a private hospital you will either need to pay for it or have private health insurance. Most people do it with private health insurance with a moderately large copayment. [It costs me $800 to go to a private hospital – as a one-off payment – and there might be additional copayments for particular doctor treatment in the hospital. Nonetheless I would get out of something dire like open-heart surgery for a couple of thousand dollars. And I would get a nice room to recuperate in…  The cost to me of open heart surgery and a knee reconstruction in a private hospital to me are about the same – the various excesses on private insurance.]

Many people with private health insurance choose to be treated in public hospitals because the service is better in the public hospital.  For instance I know of the husband of a medical specialists who chose to have his open heart surgery in a public hospital because the hospital had an excellent reputation (and they knew and trusted the surgeon they were getting).  They chose however to recuperate largely in the comfort of the (attached) private hospital.  Many people also buy private health insurance because of the tax-driven requirement to do so – but chose to get treated in the public hospital because the copayments are (much) lower.

Ostensibly all of this was paid for through a “medicare surcharge” on your tax – about 1.5 percent. If the medicare surcharge was going to cover it the tax would have had to be about 8 percent (or about 6 percent of GDP). Many Australians (though far fewer now) did not know that the medicare surcharge did not fund public provision.

Private health insurance was originally and remains almost entirely community rated. That means that a private health insurance company charges the same amount to a 31 year old as a 75 year old. Moreover there is (and remains) almost no exclusion for pre-existing conditions.  (The exclusion for pre-existing conditions usually just applies a waiting period – including some which are prohibitive such as an exclusion longer than nine months for pregnancy.) 

Anyway community rating and lack of exclusions meant that private health insurance became the province of the elderly and the ill – and eventually became basically untenable because no healthy people ever took private health insurance. To keep the cost of private health insurance down private hospitals wound up getting subsidized – but even that did not work well.

Eventually the obvious solution was adopted – which was that if you earn more than $50 thousand per year your medicare surcharge rises by 1.5 percent if you do not have private medical insurance. This means that the young and wealthy take private health insurance even if they not think they have a reasonable probability of using it. The private health insurance business again became viable. The legal inability of private health insurance to exclude pre-existing conditions means that the private health insurers do not spend money denying claims on the basis of pre-existing conditions. Legal and claims denial cost is more than 10 percent of costs in America – so that is saved.  The resurrection of private insurance (and hence private hospitals) has meant that queue rationing in public hospitals is reduced.  That has meant that “hospital waiting lists” are much less of an issue at State elections than they were a decade ago.

The community rating of health insurance has also changed in one more important way – which is that it used not to be age-rated – and it is still not age rated provided you took out private health insurance before you were 30 and you maintain it continuously. If you took it out for the first time at 35 you will pay a “five year surcharge” for the rest of your life.

There are thus strong incentives for the well to do and the young to buy community rated health insurance. Insurance companies are not allowed to price discriminate in favour of the young – but they do advertise in favour of the young. Health insurance adverts are targeted entirely at the young (with pictures of 25 year-olds with health insurance) – and believe it or not trying to match health insurance brands with ipods.

There are plenty of things not covered by either medicare or private health insurance. These are known as extras. Extras include things like physiotherapy and dental – and they are exclusively marketed to the young. Whilst the health insurance company is prohibited from bundling their marketing looks bundled. Also there are things like “sign up for extras and get an ipod”.

There have been plenty of tweaks around the edges over the years. For example the elderly on low incomes (who qualified for a full government pension) and a few other selected elderly (veterans, war widows mainly) were entitled to the primary health care and pharmaceuticals without any copayment. There arose a small number of (mostly) elderly women whose idea of a social life was to visit a different doctor and a different pharmacist each day to have a chat (and get a script and have it filled). These small numbers of women imposed enormous costs on the medical system and a very small copayment ($2) produced a very large saving. When the copayment was raised to $5 there was no correspondingly large saving. Just the $2 mattered, and it mattered a surprising amount.

Also – even with very low cost medicine there are some things that are still not delivered even though it they clearly represent cost-effective medicine. The best example is pap smears. Very few women would go to the doctor for a pap smear for a social activity. They do however represent very cost-effective medicine. Getting young women to take jabs (the new HPV vaccine) also requires a solid advertising campaign.

Also some drugs pose particular issues. Viagra for instance is not delivered at subsidy through the health care system (for obvious reasons). But you can get subsidized Viagra if you have certain medical conditions (paraplegia being the important one). I kid you not that there have been minor problems with paraplegics dealing in Viagra.

Still – on most measures – the Australian system is a resounding success. The cost (proportion of GDP, dollars) is about half the USA – but the outcomes are better across the board. And that is not diet or lifestyle related.  Australians are almost as fat as Americans.

Surprisingly the outcomes are as good or better for the rich too. The only exception is Australia’s chronically disadvantaged native (aboriginal) population.

Political acceptance is very high. The conservatives have (totally) made their peace with the system as proposing to remove it is electoral suicide. The support of the populace is almost total.

A major American hedge fund that once tried to employ me included in their pitch their (superior) access to medical care (as they are big donors to medical charities).  To an Australian that sounded odd. Nobody would advertise a job (any job) or a business relationship with access to health care. It is just assumed to be OK. The idea of going to the USA for a medical procedure is also absurd (except for revolutionary new procedures done only by say two doctors in the world). And it is just as likely that an American will come here for such procedures.  We simply do not carry an inferiority complex with respect to our medical care.

Bluntly the system works in almost every sense that matters.

From an investment and policy perspective the more interesting question why does it work so well and how can you learn from that?  I am NOT going to assert that socialist provision of services works well in general – indeed if you believe it does then you are also failing to observe facts on the ground.

I do not have the numbers at hand – but I have a fair idea of this.

There are basically two ways Australia gets much better outcomes per dollar than America. They are the unimportant (but nice) one and the important one. Given Australia produces better health outcomes at spending maybe 7% of GDP less this is a very substantial economic issue. Translated to America those savings would be about a trillion dollars per annum. [Observation: getting this more-or-less right would be one of the most important things any government would ever do…]

The unimportant (but nice) way of getting lower health care costs in Australia

The advocates of the Australian system will note that lots of primary medical care is very cost effective. For instance pap smears stop cervical cancer. Cholesterol testing might lead to better lifestyles.

The primary health care is cheap compared to the cancers and the heart conditions. If you do better primary health care you can save money in aggregate.

I believe this – and it is important from a social perspective – but I remember chatting to the Treasury health care guys (a decade ago) and they thought that this was (at best) about 1 percent of the (then about) 7 percent cost advantage Australia had. [It may be very important though in the outcome advantage…]

The important way of getting lower health care costs in Australia

By contrast the main way getting lower health care costs in Australia is to squeeze the suppliers using government controlled and often government monopoly buying.

A very large part of the difference – the biggest single part when the Treasury guys took it apart – was that doctors were paid less in Australia. Doctors (not specialists) are middle income in Australia now – earning about 1.5 times average earnings. Thirty years ago doctors earnings were maybe 5 times average. The medical schools are now majority female reflecting in part the career aspirations of women versus men. General practice for instance can be performed part time (whilst the kids are school) and is thus a common women’s career.  In regional areas Australia clearly does not pay doctors enough.  Australia often imports doctors to work in remote areas and lack of doctors is a problem in aboriginal communities, mining towns and drier inland centres.  Queue rationing is particularly bad in places that are less attractive to live.  [As I live at the beach and have private health insurance queue rationing is not an issue for me – but it is a pivotal issue in many areas.]

Suppliers in general get squeezed. For instance the Australian government pays considerably less for most pharmaceuticals than is charged in the US. Margins in lots of research driven pharmaceutical would be squeezed. Badly.

Its not all bad though. Universal coverage means that volumes go up. A drug company may sell at a thinner margin – but the volume can offset this. In most prescription drugs the incremental costs are only about 10 percent – gross margins are 90 percent.  Volume matters for profitability.

Reasons the US will never do this as well as Australia

The outcomes in Australia are surprisingly good – but they depend at least in part on the fact that Australia is small. Australia can shave margins for research driven medical products to very low levels because the research is not funded from Australia. If the US were to push margins too low they would crimp medical research.

I have no quantification of how important this is but if had to guess it would be at least about 1 percent of GDP or a seventh of the the entire savings. It may well be 2 percent. In the US context that is $150 to 300 billion per annum.  If anyone has a quantification could they please share it.  [Modification due to someone making an entirely sensible comment on my blog…]

The second reason that America will not do this quite as well is the power of the American vested interests – and those vested interests have a lot to lose because the main way lower costs are achieved is by squeezing those interests.

Winners and losers

For medical industries there are two effects going in opposite directions.

1). The government – being a monopoly buyer – squeezes margins, and

2). Universal coverage expands usage.

It is entirely possible that something will be a big winner or loser – but the savings as a percent of GDP means that the losers will be significantly more prevalent. As a rule this is atrocious for investment in medical related businesses.  The Bronte Capital blog was founded as an investment blog.  So I should state that negative up front.  However this saving – and it is a huge saving – is transferred in part to other businesses – and hence is not bad for investments in most the rest of the US economy.  If you are a manufacturer with huge health costs in America this would be a great boon.

By contrast if you are part of the medico and medico-legal establishment then any decent semi-socialised medical system is long term poison for you.  It has proven to be long term poison for doctors’ incomes in Australia.  Dentists – where socialisation has not taken root – earn considerably more than doctors these days.

PS.  The first comment on this post nailed one other major difference between Australia and the United States.  Australia has a much less expensive tort regime.  Insurance premiums are MUCH cheaper for Australian doctors and that benefit is passed on to patients.

PPS.  I would like to thank Yves Smith of Naked Capitalism for the link and comments.  Yves has lived in both NYC and Sydney and concurs with my article.  However Yves experience of the Australian system would have been biased (upwards) in the same matter as mine as she too lived in a place which was attractive to live and she too would have had the income to queue jump had something required hospital treatment.  John Barrdear’s comments are also accurate. 

Modelling Fannie Mae and Freddie Mac – Part VI

This is the money post. I put Parts I, II, III, IV and V together to come to the surprising conclusion that both Fannie and Freddie survive. This conclusion is highly-non-consensus and has substantial political and investment implications.  Also I would like to thank FTAlphaville for linking to this series – most the rest of the blogosphere has been silent possibly because I disagree with their preconceptions/ideology.   The comments on FTAlphaville reflect mainstream finance opinion – that Fannie and Freddie are irredeemably insolvent. 

Putting the model together

We now have enough to do some basic modelling of Fannie Mae and Freddie Mac. I will do it for Freddie Mac only – and leave it to the more ambitious readers to do it for Fannie Mae.*

In the second post in this series I demonstrated how the losses that have been booked to date (rather than provisioned to date) have come primarily from outside the traditional guarantee book of business. Those losses are primarily mark-to-market losses on mortgage securities (especially subprime securities), mark to market losses on the hedge book and the write-off of tax assets.

None of those loss categories are going to expand – and indeed some will reverse.

In the fourth post I estimated the losses in the traditional guarantee book of business. I have asserted that the model is fairly robust (and will cover that in the next three posts) however I showed under quite reasonable assumption that there were $37.6 billion in losses to be realised at Freddie Mac at year end 2008. Since then $2.9 billion have been realised so there are $34.7 billion left to come.

Of these losses 25.2 billion have already been provided for. From now until when the problem-years of business loans run off Freddie will only need to take another 12.5 billion in provisions. They may elect to take more than $12.5 billion in provisions – but if they do and my models are reasonable – then in all likelihood the excess provisions will be reversed through the income statement.

Now if you go to the last Freddie Mac results you will see they have a positive net worth of $8.2 billion. However they owe the government $51.7 billion, as the government has injected $51.7 billion in senior preferred securities. They are thus $43.5 billion in the hole.

They will also – over time – take another $12.5 billion in provisions. So now, until all the problem years of business have run off, they will be $56 billion in capital short.

The Government can get its money back on their “investment” in Freddie Mac provided Freddie can earn more than $56 billion over a reasonable time period and meet the government interest charges.

This would be more certain if some of the losses described in Part II reversed. I am pretty sure that they will – but lets ignore them (until a later post). Pre-tax, pre-provision operating profits of Freddie Mac are running at over $15 billion. If the government were not demanding 10 percent on its preference shares the companies would be sufficiently well capitalised to repay their interest in 4 years. With the drag of having to pay the government $5 billion per annum it will take a bit over five years. Either way the operating profits of Freddie Mac are big enough to ensure the government gets its money back. If you do the same analysis for Fannie Mae its is even better. However Fannie has less aggressively marked private label securities to market so it has less chance of recoveries from their current marks. The consensus view that the GSEs are forever toast – and forever a drain on the US Government is very likely wrong.

Implications

I have tried modelling this half a dozen ways and the result is fairly robust. If anything the GSEs (especially Freddie) are solvent quicker than the model I have presented suggests.  Indeed if the tax losses are allowed to be bought back as capital they will reach solvency a year and a half earlier – and will be in the position to repay substantial government money during 2012. 

The losses (even after all losses are booked) come from primarily outside the traditional business of guaranteeing small well-secured and documented mortgages.

Traditional GSE business (guaranteeing lower value mortgages with reasonable terms on full documentation and with a down-payment) was very effective at raising home-ownership rates whereas modern subprime lending, it seems, just caused a blip in home-ownership rates that corrected with much pain. Later in this series I am going to go through the politics of this issue. However for now it suffices to say that by the time Obama is up for re-election the Government will be in a position to ask for and receive considerable repayment from the GSEs. One of the festering sores from this crisis will appear healed.

One more implication for my investor readers (and this after all started as an investment blog). If the GSEs can repay their debt to the government – and I think that they can – then the common stock in both companies has value. That is a non-consensus view. However the real value is in the preferred securities.

The preferred securities are currently trading between 4 and 6 cents on the dollar (and went down whilst I was writing this sequence indicating my readers either do not believe me, do not have money or had no idea where I was going).

The preference shares are  all non-cumulative so you are not entitled to back-coupons when they resume paying – but they will resume paying sometime in the next 4-7 years. At 4-6 cents in the dollar that makes them a real bargain – offering 16 to 25 times your money over 4-7 years. That is a better return than you will get in most places. Even the lower end of the range offers a 50 percent annualised return. The return on the preference shares is substantially better than any possible return on the common stock.  However – and it should be noted – the conservatorship agreement gives no time period and specifies no criteria for the government to release Fannie and Freddie for conservatorship.  This means that even if this model is right – and Fannie and Freddie do recapitalise internally – there is still no guarantee you will get paid on the preferred.  Political risk is omnipresent.

Bronte’s position

At Bronte we have thought that the pre-tax, pre-provision profits were sufficient to recapitalise the GSEs for a while. We purchased large holdings of these securities below 2 cents in the dollar. Eventually the preferreds started rising leading to some financial-press scepticism that they would ever be worth anything. All I can say – at Bronte our money and our client money is where our mouth is.

There are plenty of risks to this rosy hypothesis. These fall mainly into the political risk camp (there are many people who will fight a resurrection of the GSEs). However there is model and economic risk as well. I will examine the risks (model, economic and political) in later posts.  The next three posts are (unfortunately) a little disjointed because all I am trying to do is subject my model to different data-tests and see if it is robust.  You will find that I am much more comfortable about the credit loss estimates in the model (Part IV) than I am about the income estimate (Part V). 

What makes me most uncomfortable though is the political risks – and those I have very little idea how to analyse.  Late in this series I will be very keen to see if I can get a robust discussion at Talking Points Memo – because those readers know far more about politics than me or most the regular commentators on my blog.  For the moment though what we have is Republicans (and a much smaller number of Democrats) who are extremely keen to put Fannie and Freddie into liquidation now and hence make all of this modelling entirely redundant.

 

John

*At Bronte we have done the models for both Fannie Mae and Freddie Mac. If the relevant Treasury or NEC officials wish to contact me we will provide our models more generally.

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…

Quarter	Net interest margin ($ millions)
2007 Q4	774
2008 Q1	798
2008 Q2	1529
2008 Q3	1844
2008 Q4	2625
2009 Q1	3859
2009 Q2	4255

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.

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.

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.

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.

Mr Big Wells and the new faster SEC

I just received and filled out a customer satisfaction survey from the Securities Exchange Commission.  Its prompted me to take some time off from the mega-Fannie-and-Freddie series.  I wasn’t satisfied – and the questions did not allow me to spell out all the ways that I was dissatisfied – so I will do it here.  Especially as the SEC is promising to be more responsive – and quicker.

The Bronte Experience 

On the evidence presented I beg to differ about quicker.

Sometimes something so easy to prosecute and so charmingly banal comes across my desk that I wonder if there is any future in securities regulation in the US.

I point to a small but well promoted penny stock.  The name is Cobra Oil and Gas.

This stock was pitched (by email) to Bronte Capital by a promoter who I had never heard of.  [I have been around a while – and a broker/promoter that I have not heard of makes me pause for thought…]

Cobra – according to the pitch – has some very large shale-oil reserves in the lower 48.

That alone makes it worth 15 minutes of my time.  And that is all it took…

Cobra claims that it has secured the services (as a consultant) of Dr Dualat Mamora – a renowned professor in petroleum engineering.

Cobra Oil & Gas Company is pleased to announce that the company, along with its partner Enercor Inc., has secured the use of a proprietary oil extraction process for its Utah Oil Sands Prospect. The process, known as In-situ Combustion ('ISC'), will be overseen and carried out by Vernal, Utah-based Rocky Mountain Consulting, utilizing the expertise of renowned petroleum engineer Dr. Daulat Mamora, who is an expert in ISC methodology.

This was easy to check.  I emailed Dr Mamora and received the following reply:

Mr. Hempton:

I have never heard of Cobra Oil & Gas Company, nor am I consulting for this company. I conduct insitu combustion research and publish in this area.  I guess it is just too easy to "google" and obtain a persons' name whose expertise is in insitu combustion.

Thank you for pointing the article out to me.  I am going to write to the company requesting them to remove my name from the article and from all future communications from the company.

I sent all this to the local head of enforcement at the SEC.  Receipt was acknowledged.

Anyway claiming you have a consultant who is not your consultant is probably just a little trivial.  But then I am not sure it is just the consultant who is falsified.  The CEO of the company is Mr. Massimiliano (Max) Pozzoni.  Now my Italian is not very strong – but even I can see that this name translates roughly as Mr Big Wells – a name that is entirely appropriate for the CEO of a suspect oil and gas company.  Max Pozzoni has a rather thin CV – consisting of executive positions at other pump-and-dump oil and gas stocks.  My guess is that he does not exist – but he appears (at least in voice) in this video… 

We have a CEO whose existence is suspect (and who has a funny name) and a consultant who has never heard of the company he is consulting for. 

I can think of only one reason not to close this scam – which is that somehow you can find Mr Big Wells (whoever he might be) – and you are preserving it all for criminal action.  But the right action is not a suspension (though the SEC should do that too).  The right action is to suspend the stock, chase the seller of the big parcels and invite the Justice Department to press criminal charges.  If the CEO cannot be found the company should be wound up. 

For now however it seems that the new faster SEC will be too slow and the baddies will get away with the moolah…

That however is not the reason I am writing.  Mr Big Wells is probably better described as a small dip-stick. 

By contrast, I have thrown the SEC a very solid argument that a billion dollar plus New York Stock Exchange listed oil and gas company is largely fraudulent in its statements to the market.  I know the relevant regional head of enforcement (the same regional head) is informed as to the issues.  Unlike Cobra however this is a complex case – and I think I should give the SEC time to do its job before I go public.

After all, its a quicker more responsive SEC and I shouldn’t have to wait too long…

Modelling Fannie Mae and Freddie Mac – Part III

In the previous post I showed you what had caused the big losses at Fannie and Freddie to date.  In short it was mark-to-market securities (on private label securities and the like) and interest rate hedging instruments that collapsed in value as interest rates went to zero.

I also showed that these losses were not likely to continue to be a drain on Fannie or Freddie. 

What matters now is the vast (multi-trillion dollar) books of traditional business that they guarantee – mom and pop mortgages by people with good credit and no fancy mortgage terms or liars loans.  These have not caused many actual losses to date (less than $6 billion at each company) but the provisions for losses from this business are large and getting larger. 

It’s the future losses we need to worry about.  And so now – unlike in the last post – I need to make estimates about the future to see what losses will be.  Casey Stengel argued you should “never make predictions, especially about the future”.  At the risk of being exposed as a fool I am going to breach Mr Stengel’s advice. 

However I have some tools for making these predictions.  The purpose of this post is to introduce readers to the tools…

Default curves that point to the sky

Both Fannie and Freddie publish default curves by vintage.  Here is the Freddie Mac curve from the last quarterly results…

And here is the Fannie Mae curve from the last quarterly…

(click these pictures for more detail…  you can find originals in the credit supplements both companies release…)

These curves show the cumulative default of a pool of mortgages (as a percentage of the original pool balance) over time. 

Note that Freddie Mac defaults are lower in all recent vintages than Fannie Mae.  I posted on that on this blog and asked for explanations.  The correct explanation was given (and I have since checked it).  Almost the entire difference is that Fannie Mae did considerably more business with Countrywide and IndyMac – and hence has a worse book of business in aggregate.

Also note that the curves for the 2006 and 2007 years in particular are very sour at both companies.  2005 is a bad year (but probably manageable) and 2004 and prior years will cause few problems.

Default not loss curves

These are default curves not loss curves.  To turn them into loss curves you would need to know the severity by vintage and neither Fannie nor Freddie publish enough information to work that out (though you can get some reasonable estimates from the published data). 

Take again the Freddie data.  The 2000 vintage pool (meaning all the mortgages guaranteed by Freddie Mac in 2000) has had a cumulative default of about 1.07 percent.  That means that 1.07 percent of the mortgages written in that year defaulted.  Prior to the current mortgage bust 2000 was considered a bad year of business.

Nonetheless 1.07 percent default did not cause any problems for Freddie because the severity (loss given default) was less than 10 percent.  The 1.1 percent default caused about 10 basis points of loss over a decade.  Given the guarantee fees were almost 20 basis points per year this pool of business was profitable.

The problem with the 2006 and 2007 vintages is not only is the cumulative default quite large but the severity will also be very high.  Fannie Mae severity during the last quarter was over 45 percent.  High defaults multiplied by high losses given defaults means big problems.

How big – and how you might model them is the subject of the next post.

Modelling Fannie Mae and Freddie Mac – Part II

Advance apology – this is the most complicated post in the entire series… I promise if you persevere through this post you will find the rest of the series easier going… also – to state the obvious – it helps if you start with Part I. 

This post is entirely about the losses that Fannie Mae and Freddie Mac have realised to date.  It is not about the losses that they will realise in the future.  Models of those losses will be provided in Part IV in which I model the traditional guarantee business. 

Background

In the previous post I demonstrated (at least for Freddie Mac) that the vast bulk of the losses realised to date by the GSEs have not come from the traditional guarantee business. In this post I promised to explain where they did come from. For that I need to explain what else Fannie and Freddie do.

In short Fannie and Freddie not only guarantee mortgages – but they own mortgages and mortgage related securities. It is in the owning of mortgages and mortgage related securities that the vast bulk of the problems arose to date.

When the GSEs buy a mortgage they finance it by issuing debt. This is different from the “traditional guarantee business”. In the traditional guarantee business the GSEs take only credit risk.

When they buy mortgages and hold them they bear many types of risk. These are:

(a) refinance risk in that they might not be able to continue to borrow money – especially short term money – but they own long dated mortgages. If they cannot maintain access to borrowing they will fail.

(b) Mark-to-market risk – because some of what they own is not mortgages but mortgage related securities which are marked to market and derivatives which are marked-to-market,

(c) Credit risk as some of the mortgages they own might default, and

(d) Interest rate risk – because the term of the mortgages they hold will differ from the term of the borrowings they make – and if interest rates change they might wind up with a mismatch in their book of business (say owning 6% yielding mortgages when short term rates have risen to 11 percent).

All of these risks have caused problems for Fannie and Freddie at various times.

Refinance risk – the cause of the conservatorship

In the lead-up to September last year the spreads on Fannie Mae and Freddie Mac debt widened. The US Government refused to explicitly guarantee Fannie and Freddie debt and there was a period when Fannie and Freddie could not roll their debt.

This was a crisis. Fannie and Freddie own long dated mortgages and issue (some) short dated debt. If they could not roll their debt (ie borrow to replace maturing short-dated borrowings) then they would fail.

Mr Paulson put them in conservatorship. Neither Fannie nor Freddie breached their capital adequacy standards when taken over (though both would eventually have breached them).

Failure to roll debt in a crisis is not normally grounds for taking over a bank (though many argue it should be). Every large bank in the world could not roll its debt without explicit government support by December. Even the mighty vampire squid (Goldman Sachs) issued government guaranteed debt.

That said – if you can’t roll your debt you either fail or need government intervention and intervention was an understandable choice (though one both this administration and the previous was not prepared to make more broadly).

Once the government guarantee came the Fannie and Freddie refinance problem went away – and bad deals done during the pre-conservatorship stress are only a small part of the realised losses of either Fannie or Freddie.

Problems caused by mark to market risk

Mark-to-market risk on mortgage securities has been the biggest cause of losses at Fannie and Freddie to date. Fannie and Freddie not only insured the (relatively) conservative traditional business but they purchased senior tranches (usually rated AAA) of securities backed by non-GSE mortgages including subprime, alt-a and other toxic dross. This drift outside their traditional domain (sometimes justified by their “housing mission”) is the core thing that blew these companies apart.

The losses on these have been extraordinary – and these losses, rather than being provided for over time, are run straight through the balance sheet. When you provision for losses you tend to provision for the losses over time against your ordinary operating income. [Bank of America seems to produce provisions roughly equating to its operating income each quarter.] Mark to market losses by contrast come when the market tells you they are there.

During the first quarter of this year the quotes in the markets for such mortgage paper got very wide. A lot of paper was bid 20, offer 80 – meaning the seller wants 80c in the dollar and the buyer is only prepared to pay 20 cents. In reality the market was there in the first quarter – and the real price was at the bottom end of that range though many subject to mark-to-market accounting refused to acknowledge where the market really was trading.

At the time there were massive squeals about the irrational market in this paper - with the accounting authorities eventually granting lenience. Nonetheless misrepresentation about the value of the paper was the norm. There were plenty of instances where the paper was bid 20, offer 80 and marked at 85. Companies that marked their securities that way have not (at least in their measured accounting) benefited from the massive bounce in the markets since March.

Freddie Mac however marked its securities as harshly (or more harshly) than any major financial institution I follow.

Here are the marks as presented in the Freddie Mac first quarter SEC filing.

(please click for more detail).

These marks are extremely harsh. For instance the subprime has (mostly) about 20 percent excess collateral – so the $63,693 million of subprime securities held are backed by roughly 80 billion in mortgages. For this to be worth only $46 billion (as marked) the losses had to represent 42 percent of the outstanding pool. That might be possible – but it requires say 60 percent defaults with mortgage recoveries of 30 cents in the dollar.

There are some pools of mortgages that are behaving that badly – and a few pools which are behaving worse. However I went and looked at a bunch of mortgages that backed pools owned by Freddie Mac – and whilst they were behaving badly they were not behaving quite that badly.

That said these loss estimates are not absurdly high either. The delinquency on the first-liens mortgage backing the subprime part of this book seems to have stabilised over 40 percent.

Nonetheless Freddie classified the $48.6 billion of losses as either “temporary” (where they thought the market losses would reverse) or “other than temporary” where they thought the losses reflected in market price would be made permanent by actual default. They thought that 13.8 billion would be “recovered” at the end of the first quarter and they seem to have increased their recovery estimate. They seem justified in this because they received $10 billion in principal payments on the suspect categories of loans during the last quarter – and defaults are (of course) impossible after the principal payment has been received.

Anyway it is clear that the biggest losses for the GSEs came from the private label securities – the stuff that was outside the original GSE business. The end point of these losses is unknowable – but in the case of Freddie Mac at least – the estimates made in March seem on the harsh side. [I expect recoveries – albeit smaller recoveries – against the estimates made by Fannie Mae as well.]

Fannie Mae has published the performance of private label securities owned by Fannie versus the average private label mortgage security in the market. The ones owned by Fannie are performing substantially better than the market. There is some evidence that better-than-average buying of dross is a character of Freddie Mac too. They purchased the best bad mortgages!

If this is the case then the marks (and the losses) shown in the above table are gross over-estimates.

I have to make the obvious observation here. The biggest losses for the GSEs were cane from owning non-GSE mortgages – ones originated entirely outside the government system. Cynically I have heard supporters of the GSE mission state (and for good reason) that it wasn’t our (meaning "traditional") GSE mortgages – it was the free-market mortgages that killed the GSEs. Said to the Republicans: “your guys did it”. Of course nobody forced the GSEs to commit hari-kari by stepping outside their remit of conservative mortgages. Nonetheless we should nail down clearly what killed the GSEs – and it wasn’t the traditional GSE business.

Problems caused by credit on owned mortgages

A mortgage that Fannie or Freddie owns can cause it credit losses just as surely as a mortgage that Fannie or Freddie guarantees. The mark-to-market losses in the last section will either reverse or eventually become credit losses (when the loans do not repay). Indeed mark-to-market is (in large part) the market’s estimate of future credit losses.

There will be credit losses on the private label securities that Fannie and Freddie own. Huge credit losses. It is my view (backed by the market movement of recent months but not always backed by market movement) that the mark-to-market losses overstate the end losses somewhat.  Freddie thought at the end of the first quarter that the mark-to-market losses overstated end losses by the above mentioned 13.8 billion.  They think the overstatement is even larger now…

Problems caused by interest rate risk

Interest rate risk has caused the bulk of Fannie and Freddie’s past problems. The hedges for interest rate risk are an issue this cycle too.

Fannie and Freddie have enormously complicated interest rate risk management issues. The reason is that nobody knows how long a mortgage will be owned for. The borrower can repay the mortgage at almost any time, usually with little or no penalty.

This makes it very hard to match the financing to the mortgage. For instance if you think the mortgage will last ten years you might choose long dated finance. If rates fall sharply the long dated finance will remain outstanding (costing you a high rate) but the mortgage will refinance to a low rate. The GSEs face what is known in finance circles as “negative convexity”. I see no reason to go into the nuance of this – but suffice to say that the GSEs have large and complex derivative books to deal with this "duration" issue.

The accounting for those derivative books is problematic. Sometimes the derivatives need to be marked to market. Sometimes they can be hedge accounted. It was the accounting for these derivative books which caused the scandals at Fannie Mae and Freddie Mac in 2004-2005.

Strangely the derivative accounting caused some losses at both Fannie Mae and Freddie Mac when they went into conservatorship – caused by the conservatorship.

This needs explaining though be warned that the explanation marks me as a wonky nerd who reads GSE accounts for fun.

Fannie and Freddie owned mortgages (fixed rate) and financed with shorter-dated floating rate paper. They were at risk if interest rates rose – in that they would not be able to maintain their cheap borrowing. To hedge this they purchased “pay fixed swaptions”. This is terrible jargon – but a swaption is an option over an interest rate swap. A pay-fixed swaption is an option to fix your interest rate (with a swap) at some stage in the future.

Pay fixed swaptions would be worth more if interest rates rose (as the right to fix your interest rate at some level is worth more when interest rates are high). Pay fixed swaptions were worth less if rates fall because the option to fix your rates at some pre-determined level is not attractive when rates are low.

If the swaptions were marked-to-market through the accounts it would make Fannie and Freddie’s accounts very volatile. Instead though Fannie and Freddie used hedge accounting – where they spread the cost of that swaption over the period of the mortgages which it was meant to hedge and ignored the mark-to-market considerations. That is reasonable enough accounting.

When the companies went into conservatorship though it was not certain that they would be allowed to continue to hold the mortgages which the swaptions hedged. This made the hedges “ineffective” under accounting standards and meant that the hedges needed to be marked to market immediately.

As interest rates collapsed at around the time of the conservatorship the marks on the swaptions were large and negative. Going into conservatorship caused over $10 billion in accounting charges at Fannie and I believe even larger charges at Freddie.

It is easy to overstate this problem though.  Many of the items that were hedged transited to mark-to-market accounting.  That would have been fine except at the time the mark on many of the mortgage assets that transited was very poor.  One expert on Fannie accounting tells me that this is theoretically a non-issue though it is a practical issue with respect to at least part of the book.  I do not know the net effect on Fannie and Freddie accounting of this issue but it is almost certainly less than the $10 billion mentioned in the last paragraph – possibly much less.  The $9233 unrealised gains on Freddie Mac securities disclosed in the above table is (I gather) part of the partial offset.

These accounting charges are temporary. Fannie and Freddie still own mortgages that yield (say) 6 percent. They are now financing some of those mortgages at very low rates and the spread is higher-than-it-would otherwise be. Usually those high spreads would be offset by the losses on the hedge instruments as the swaptions expired worthless. However those swaptions have already been written to near zero. Fannie and Freddie are reversing those accounting charges through the net interest income line. If you don’t believe me have a look – the net interest income of Freddie Mac was $1.5 billion in the second quarter of last year and $4.3 billion this year. That is enormous…

Not all of that gain is reversing previous charges – a fair bit is simply the reduction of competition in the aftermath of the financial crisis. But the much higher operating income of Fannie and Freddie will go some way to reducing government exposure.

Tax effects

It is trite to note that Fannie and Freddie have taken huge charges against tax assets.  That is inevitable when the government has not made clear its policy and hence Freddie and Fannie cannot even be assured that they will exist to earn income to offset losses.

Summary

It is in the non-traditional guarantee business that Fannie Mae and Freddie Mac have reported the huge losses which leave them in such a precarious position. Some of those losses (particularly the losses on the hedging book caused by the conservatorship) will reverse. Some (end credit losses on junky subprime mortgage securities) will not.

That said – none of these loss categories is likely to expand in the future. If the GSEs wind up being a toxic mess for the government it won’t be on the losses already incurred – it will be on future losses.

And that leads us to the traditional GSE business of guaranteeing ordinary qualifying mortgages.

The next post will introduce the tools for modelling that business – and the two posts after that will actually do the model.

Thanks for following this far. I know it is complicated. The next post is easier …

Modelling Fannie Mae and Freddie Mac – Part 1

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.

John

*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...

Stink boats and the forthcoming spectacular inventory bounce

Paul Krugman has been predicting a double-dip recession based on an inventory bounce. He figures that middle to latter part of this year will have an inventory bounce which will (briefly) make the economy look good again – but will not (in his Keynsian world view) bring back the fragile flower of true sustainable demand and hence will not result in sustained recovery.

That said – the inventory bounce might be very spectacular indeed. I wish to illustrate with an (admittedly) extreme example – the manufacturing of recreational motor boats (scornfully known in the Australian vernacular as “stink boats”).

Stink boats are obviously high value highly discretionary items – and they should be (and are) ground zero for the massive swings in discretionary consumption in the global economy. That said the issues in the stink boat industry are highly exacerbated by problems with “floor plan finance”.

Floor plan finance is the provision of finance to dealers (cars, boats, RVs, manufactured houses etc) to finance trading stock on the dealer’s floors. Floor plan finance has become more difficult to obtain and (far) more expensive – so dealers are responding in the rational manner which is to cut back floor stock.

By far the most extreme illustration I have seen is Brunswick Corp – the world’s biggest recreational boat maker. The stock has been a wild ride going from $45 to sub $2 and back to $8. It is operationally and financially levered to the centre of the storm…

Anyway here are some annotated extracts from the last investor conference call…

End retail sales are down 25-40 percent – see this quote:

First, let me review some of the preliminary second quarter U.S. Marine industry data, starting with fiberglass, sterndrive, and inboard boats, which fell by 34%. In the prior two quarters, the rate of decline was higher, in the 45% to 47% range. In the second quarter of 2008, units fell by 35%. Outboard fiberglass boat retail unit demand fell 30% in the second quarter of 2009. In the previous two quarters, declines were higher, in the range of 40% to 41%. In the second quarter of 2008, units fell by 25%.

However the dealers are choosing to reduce their floor-stock at least in part driven by the financing costs for this…

Now let's turn to some key factors that influenced our wholesale demand, that is, the boats we sold to our dealer network. In addition to the underlying retail demand, another factor that is having an effect on overall wholesale demand is the availability and cost of floorplan financing. Several traditional floorplan lenders have exited the market, or materially reduced their exposure, and the remaining lenders have imposed stricter lending criteria as they seek to protect the quality of their loan portfolios. Although Brunswick dealers continue to benefit from the financing availability provided by BAC, our joint venture with GE, beginning April 1, dealers became subject to revised terms, including higher financing costs and loan curtailment payments. These changes translate to higher costs for dealers to carry inventory, which has led Brunswick and our dealers to reassess and ultimately reduce wholesale orders. This will ultimately lead to a healthier marine environment, with lower inventory levels held in the dealer system.

The net effect is that they have reduced their sales to dealers by 60 percent – see this quote:

In response to these market factors, and our strategy to do all we can to protect our dealer network, we have reduced the number of units that we sold to dealers nearly 60% in the second quarter versus last year. This is the same percentage decline experienced in the first quarter of 2009.

As a result of our reduced wholesale unit levels and the impact of higher discounts, Brunswick's boat segment sales declined by 77% in the second quarter, compared to the decline of 64% in the first quarter of 2009.

But it gets worse – the company has stripped itself of inventory –

As we execute our strategy to maintain high levels of liquidity, and assist the dealer network in this weak Marine market, our production rates during the quarter were well below our wholesale unit sales. This lower network production reflected about a 75% decline in units produced versus the second quarter of 2008. This compares to our 60% decline in the second quarter wholesale units, which I have previously mentioned. More importantly, in our fiberglass boat businesses, our production levels were about 13% of our retail demand, and in our engine business, overall production was reduced by approximately 65%, this follows a 75% reduction in the first quarter.

So what do we have

• End sales down 30 percent

• Dealer sales down 60 percent

• Production down 75 percent

Or – as they put it

We produced 13% of what the dealers actually retailed, in terms of even numbers.

Obviously these numbers are unsustainable and either retail sales have to dramatically fall from current levels (unlikely) or production has to grow dramatically...

How else do you spell inventory bounce?

My guess is that the inventory bounce here will be so big as to restore pricing power to (of all things) luxury recreational motor boats manufacturers.

This looks like a V-shaped recovery – at least for stink boat manufacturers.

Whilst there are inventory shortages in far more important industries (see this story from the WSJ about auto-dealer inventory shortages) they won’t quite be of the scale of Brunswick. But the risks to the inventory driven manufacturing economy are in my view (and quite surprisingly) to the upside.

Whether Professor Krugman is right - and the inventory bounce is followed by a double-dip - on that I will reserve judgement. But he is right such a large proportion of the time that when the euphoria of the inventory bounce is upon us I will be very nervous...

Ethics, journalism, the web and the profits of brokerage businesses – oh, and Paul Krugman

Tyler Durden of Zero Hedge has responded to this blog post - and his comments - which I should fairly highlight - are reported at the end.

One of the perils of having public opinions is that people publicly misquote or misrepresent you.

My first introduction to Talking Points Memo was a Muckraker column which erroneously attributed offensive views about Sheila Bair to me. I dislike Sheila Bair intensely but the views in the muckraker column were not my views. The whole issue was solved with an email. Within 30 minutes TPM corrected their post and posted an apology. No harm was done. The amended TPM post can be found here. The original post is (fortunately) lost to the web and I can’t even find it in the Google archive.

The web (and blogging in particular) allows you to do this – to shoot from the hip and to correct where appropriate. Sometimes the correction should be total withdrawal of the offensive idea (as TPM did) – the test being about defamatory and clearly incorrect. Mostly it should be additional notes or follow up posts describing the world as nuanced.

At the moment I am having trouble with Julian Delasantellis who hails from America but writes for the Asia Times. The Asia Times describes him as “an educator in international business from the US State of Washington”.

His quote about me is as follows:

“John Hempton of the Clusterstock blog suggests that Goldman is brokering sovereign wealth fund (SWF) purchases of US and British debt securities, but it is doubtful that the sharp operators running the SWFs would be leaving this many crumbs on the table.”

Alas I never said anything of the sort. The original Clusterstock article is here and you can compare yourself. I want to correct Mr Delasantellis because it gives me an opportunity to explain to a wider audience the way I believe the broking industry really makes its profits…

I have always thought the trading profits come from intermediation and not from broking. My view: traders at a desk sit all day and see prices (or create them by finding suckers to hold their residual risks). They see if they go long this exotic piece of debt (say a mortgage instrument or a corporate), buy a credit default swap (and hence pass the risk to someone who is sometimes a sucker), hedge out the interest rate risks (with swaps mostly) and fund the entire thing by going short a Treasury bond then they can make an “arbitrage profit”. What they have done though is funded exotic debt (mortgages, corporates etc) by increasing the supply of vanilla debt (treasuries).

They could do the trading either way – they could buying the Treasuries and shorting the corporate debt – however the market is biased one way – it is biased to make profits by going long exotic, hedging and shorting Treasuries.

The reason why it is so biased is that there is in the world a huge demand for vanilla debt (as the Chinese and others want to own Treasuries) and a huge supply of exotic debt (because the spendthrift in English speaking countries and Spain keep borrowing to fund housing and their lifestyles).

The investment banks – through their trading books – at least in part – intermediate the current account deficit. That is the main source of the risks I think investment banks are taking and where the “trading” profit comes from. I thought – and still think – that high frequency trading is a distraction (even though it imposes a small tax on many market participants).

I have written about broker profits extensively on my blog trying to quantify the intermediation profits (only partially successfully). Here are links to the main series (see Part 1, Part 2 and Part 3).

The balance sheets of the investment banks have got so huge (cumulatively about 6 trillion dollars last time I aggregated them) precisely because there is so much intermediation to do. Brad Sester used to “follow the money”, I tried to work out the mechanisms by which they money flowed that way.

Julian Delasantellis through misrepresenting my views established me as a straw man who he could demolish in a single sentence. This enabled him to (incorrectly) argue that a high degree of Goldman Sach’s profits come from high frequency trading.

He has refused to issue a correction because he has refused to undermine his own argument. Talking Points Memo was quick to issue a correction – where as Delasantellis was not. The ethical thing to do would be to clearly amend the paragraph and write a short note at the end of the web article. In this case I can’t tell whether Mr Delasantellis’s apparent lack of ethics reflects insecurity or incompetence. Whatever – it clearly illustrates how – without high ethical standards – faulty arguments get made and amplified by the media.

But the whole high frequency trading debate has had that character. What has happened is that a consistent campaign by an anonymous blogger taking the name of Brad Pitt’s Fight Club character (Tyler Durden) has managed to elevate high frequency trading from a fringe activity (although one that does impose costs on ordinary investors) to the centerpiece of Goldman Sachs control of the universe through market manipulation. Weirdly he has widespread acceptance of that view – and a consistent web campaign has actually got US Senators interested and the SEC wanting to clamp down on some of the practices.

I suspect that these campaigns can be successful because (a) there is a predisposition to think that all that Wall Street does is evil and (b) the quality of financial journalists is on average low (with Mr Delasantellis just being an extreme example).

Contra: even Paul Krugman however (a man with very high standards) has jumped on the high frequency trading bandwagon – but to give Krugman his due he has reread one of the many brilliant articles by Kenneth Arrow and pointedly not given any quantification of how big an issue it is.

A rare economic experiment

Now we have one of those rare experiments in economic punditry. Goldman Sachs has issued a statement that says high frequency trading is less than 1 percent of Goldman’s revenue and less than one percent of their capital employed. That of course translates as “banning it would have no material effect on Goldman’s profits”. And due to the successful campaign by “Tyler Durden” much of the abusive high frequency trading looks like it will be banned.

If – ex post – Goldman’s profits do not take a catastrophic hit on the ban then hey – the whole HFT thing was (as I suspect) a storm in tea-cup. Krugman’s refusal to quantify will be endorsed and Mr Delasantellis will look like the fool he appears to me to be.

But the experiment could pan out the other way – in which case you will see this blog clearly state the mistake I have made.

However this is not to gloat about formalised economic experiments (rare and exciting though they may be). There are huge risks in the balance sheets of investment banks – as the world found out when Lehman Brothers failed. Unless we understand those risks we do not know how to control them. Once in the last 100 years we had major financial re-regulation in response to an economic calamity – and much of the Great Depression legislation has served us well (see this example – Part I and Part II).

We have another once-in-a-lifetime opportunity to get this right – and the high frequency trading debate has wasted precious time, precious column inches and hence part of that precious opportunity.

So I will reissue my plea – can we get the debate focussed back on what really matters.

John

PS. I have no idea as to whether Tyler Durden and his Zero Hedge blog represents the lobbying efforts of a traditional market maker. But competition from high frequency trading has slashed market making margins and regulators are rushing to reassert the old status quo. An anonymous blog consistently pushing an economic issue (any issue) deserves to be treated with far more skepticism than Zero Hedge has been met with. Very well executed anonymous blogging (and Zero Hedge is a great blog) might turn out to be very effective lobbying.

PPS- Tyler Durden has responded to this blog post - here are his comments...

Ethics, journalism, the web and the profits of brokerage businesses - oh, and Paul Krugman (Bronte Capital) - John, I can put it on the record that Zero Hedge represents no lobby interests and has never received any compensation either direct or indirect in its fight for market transparency, and stands to benefit in no way from the market topology either changing or staying the same (aside from the 0.5% of total market cap price I pay for liquidity any and every time i trade a stock, and which fee, which I disclosed in my observations on Implementation Shortfall, you failed to bring up in your cost-benefit analysis, and whose bottom line as to liquidity costs is dramatically different from your figure). While I am sure you can provide the same disclaimer, to say that a simple blog can dictate policy is a little far fetched (also, not sure how your journalistic colleagues feel about your condesending opinion of them, who, by your statement is a virtual majority, of everyone out there). Or maybe not, if your null assumption is that regulators were letting illegal activities go on for years and are now backpedalling once someone dares to shine some light. In fact, once Flash Trading is done away with, Zero Hedge is fully intent on exposing Dark Pools for the opaque, "liquidity providing" yet liquidity fee gobbling, IOI-based machinations they really are. Oh, and as a total aside, Goldman's record $100MM+ trading days in Q2, and Medallion's 40% compounded returns since inception at a 5.0 SIGMA (I am sure you understand what that means) - that's totally unrelated to HFT as well.

My comment on Tyler's comment:

I am entirely convinced that Goldman's returns do NOT come from high frequency trading. However I am far less convinced of the source of the Medallion returns. Renaissance Technologies does have fantastic returns - and nobody seems to understand where they come from - and they DO trade a lot.

I note however that Renaissance Technologies returns have dropped dramatically in the past year - and many (including me) have speculated it is because algorithmic trading of all kinds is subject to far greater competition. More competition usually lowers profits.

The argument that Goldies blowout trading profits have been caused by their recent forays into high frequency trading is absurd. Everyone I know of who has hugely electronic trading systems is making less money - not more - and they are making less money for the entirely expected reason - which is competition.

Finally - yes I think the majority of business journalists are dreadful - at best parroting the received opinion of the day or corporate press releases. There are some very noble exceptions - Peter Eavis (WSJ), Bethany McLean (Vanity Fair), Joe Nocera (NYT) spring to mind. These journalists have done outstanding work - and Nocera wrote one of my all time favourite books. But yes - business press is difficult to read for a reason - which is that the standards on average are low.

That I should be criticised for arguing that business journalism is on average a low standard is comical. Six hours watching CNBC will convince you of that. Or Fox business, or reading the business section of any major local newspaper. Quality business journalism is really hard and few do it well - though the reporters mentioned in the last paragraph do it very well indeed. The reason it is hard is that everyone has a vested interest and the stories are often complicated.

Very high quality books like David Einhorn's Fooling some people all of the time would not have needed to be written if business journalists had taken up the story earlier...

The low standard of business journalists is one reason why fine blogs (like Zero Hedge) are worth so much time - even when I do disagree with them. Some of the best journalists are also bloggers (Felix Salmon for instance).