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).

Follow up on high frequency trading

My last blog post on high frequency trading got a surprisingly wide reception – and was reprinted for several different audiences. The comments at Talking Points Memo were muted and did not touch the general angst about this issue. That is not surprising – that is a politics driven audience. The commentary at Business Insider was outright hostile with the general consensus being that I am an idiot. The reception on my own blog was balanced – with several people pointing out mistakes I made (and I made a few) and with most talking about the argument on its merits.

Still – one lesson – if you write an article that is not outright critical of Wall Street practice then you should expect to be called an idiot. I got endless emails asserting my stupidity.

All I wanted to really understand what the risks Goldman is taking to make all those trading profits. Sure I know most of them are fixed income – but the balance sheet is still in the trillion dollar range and this crisis has proved that ultimately these balance sheets get socialised. If taxpayers are ultimately on the hook then it is incumbent on taxpayers (at a minimum) to understand and manage the risks that they are taking through their regulatory agencies.

Anyway back to the hot-button issue which is electronic and high frequency trading.

First – let’s discuss front running.

I gave an example of a stock that was bid $129.50, sell $131.50. I bid $129.55 and immediately a computer bid $129.60 over me. I called this front running.

I stand corrected – if someone (even proprietary traders associated with my own broker) bids $129.60 over my bid of $129.55 they are not committing the crime of “front running” – but using the public information in my bid to make a different bid.

It would only be front running if they (a) worked for my broker and (b) organised to have their bid filled preferentially at $129.55.

Of course from my perspective it makes not a rats difference whether they got in front of me at $129.55 or $129.56. That difference is less than 0.01 percent and if you are in my business (strict fundamental investing for medium and long term) it makes no sense to be worried about that sort of percentage. Front running as a crime might have mattered when notional spreads were wide and we did not have 1c pricing. But now the issue is just pricing over me and my clients - not whether those orders are legal or otherwise.

The issue is not front-running per-se (except maybe using my broader – non-criminal use of the term). The issue is that more often than not, as a smallish institution, we are forced to go to the middle of the spread or often cross the spread to get filled. Traders – whether they be bots or the old fashioned screen addicted traders of yore make a good proportion of their profits simply by consistently earning spreads. One old Sydney Futures Exchange trader (open outcry) admitted that (unsurprisingly) was how he made his living. Traders make profits on their short term positions (and sometimes make surprisingly good returns on equity). Those profits come out of somewhere – and I am not averse to the notion that Bronte and its clients pay a small share of them. I am not averse to the notion that clever algorithmic traders effectively “tax” other market participants (and I am not particularly scared of that loaded word “tax”).

Nonetheless the tax is small and the issue is not and should not be a target for major reform. The attention played in the blogosphere – driven in part by Zero Hedge – is simply not warranted.

To quantify: these days the spreads are often 1c on $15 shares (say 0.07 percent) and I can easily get brokerage at a tenth of a percent. I can often buy more than enough stock at the high end of spreads. Even if I lose to the algorithmic traders every time (and I accept that I do a fair bit) then – hey – I am paying 0.15 percent for trading. That is a lot better than it was in the old days when brokerage fees were fixed, large and non-negotiable.

Moreover as a fundamental driven investor the turnover in my portfolio is low. Ideally we will turn over less than once per three years – but as market volatility is high we seem to be getting more opportunities for good switches than that. I can’t imagine how the switching costs for Bronte Capital’s portfolio are higher than they were before brokerage reform even with the “tax” that high frequency traders impose on the rest of the market. [Likewise we trade currency with spreads of 1 point (ie down to the hundredth of a US cent). Only a few years ago we traded with 5 points of spread.]

This issue is – as I suggested – a distraction. There are plenty of real issues for financial reform – and one of the most important in my view being the large and seemingly wholesale funded balance sheets of investment banks. Nobody really understands these balance sheets but ultimately we (though the tax base) are guaranteeing them. That is what the slogan “no more Lehmans” means.

Can we focus where it matters? HFT remains a distraction.

John

PS. Thomas Peterffy pointed out in the comments to my last post that fairly good algorithmic trading is available to small institutions like Bronte at very low fees. (He should know – he is probably the single most important driving force behind electronic trading globally. However he is selling his own service.) If anything these programs reduce the “tax” paid by ordinary institutions such as Bronte even further. Peterffy thinks his algorithm tends to beat the electronic traders. We have not experimented enough to back that conclusion.

PPS. A reasonable summary is that old-fashioned traders earnt big spreads with quite a deal of sweat and only a modest degree of certainty. New fangled high frequency traders earn small spreads with high frequency and ruthless efficiency. But they are still smaller spreads.

PPS. Quantifications of this as a $20 billion issue are insane. Felix Salmon once took umbrage at my assertion that the pre-tax pre-provision profits of the financial sector in the US were at least $300 billion. That looks like an underestimate. He however swallows this insane number without too much question.

High frequency traders – a phoney explanation when nobody seems to know the real explanation

There are a few changes to this post in italics. These come from the comments.

Goldman Sachs made 5.7 billion dollars of trading revenue in the last quarter. That run rate (over 22 billion per annum) is almost as much as the pre-crisis peak.

$22 billion per annum is roughly $200 per year per household in the United States.

If it is someone’s trading revenue it presumably comes out of someone else’s pocket so measuring it per household is appropriate.

The trading revenue of “Wall Street” major investment banks (including Barclays, the trading parts of Citibank and similar entities) peaked at over $500 per household in the Western world.

Revenue like this is usually paid for a service. Ultimately I thought the service was intermediation between savers in China, Japan and the Middle East (who want Treasuries) and dis-savers in the Anglo countries (who want to fund exotic credit card debt and mortgages). That remains the only service that looks large enough to justify that sort of revenue. [The real service having been finding suckers such as municipalities and insurance companies to hold the toxic waste such as CDO squared resecuritisation paper.]

That said, given almost nobody knows how to make $22 billion per annum trading and jealousy is a common trait, conspiracy theories abound. The current conspiracy theory is that this money comes from front-running clients in the market with very rapid trading. The New York Times recently promoted this view.

The idea is that by knowing client orders you can extract profits. Computers fleece clients by forcing clients to pay more when they buy and to receive less when they sell.

And it is clear this happens. We trade electronically at our fund. We were recently trading in a stock with a large spread. I have changed the numbers so as not to identify the stock – but the ratios are about right. The bid was about 129.50, offer was about 131.50. We did not want to cross the spread – so when we bid for the stock we bid $129.55. Within a second a computer (possibly at our own broker but it makes no difference which broker) bid $129.60 for a few hundred shares. We fiddled for a while changing our bid and watching the bot change theirs. We would have loved to think we were frustrating the computer – but alas it was just a machine – and we were people up late at night

Actually obtaining the stock required that we paid up – and when we did so it was probably a computer that sold the stock to us.

Inevitably we cross spreads and the computer earns spreads.

The computers make even more consistent profits with high volume low spread stocks. If you are buying or selling Citigroup it is almost certain that when you buy you will pay the offer price and when you sell you will receive the bid price. They are only 1 cent different – but in almost all cases it will be a computer that traded with you – and the computer will – through owning the “order flow” be getting the better end of that deal.

That said – these profits can’t add up to sufficient to explain Goldman’s trading profit.Interactive Brokers is (by far) the most electronic and lowest cost broking platform in the world.We use it extensively as do many others. Interactive Brokers has a 12 percent market share in option market making globally and probably a 10 percent share in all market making. Trading revenue was about 220 million. Moreover in the conference call the CEO/Founder (Thomas Peterffy) thought the influx of competition in the area had reduced market maker margins very substantially.

Anyway if 10 percent of global stock volume provides 220 million dollars revenue per quarter then there is no way that a substantial proportion of Goldman’s trading profit can come from high frequency trading. The numbers do not work.

When the New York Times quotes William Donaldson (a former CEO of the New York Stock Exchange) as that high frequency trading “is where all the money is getting made” they are quoting bunk – and they should know it.

This is a plea. Can we have a dispassionate and accurate view of where the (vast) trading profits of Wall Street in general (and Goldman Sachs in particular) come from? The last big boom in trading profits was followed by a bust which came at huge social costs. [Look what happened to Lehman.]

We cannot understand the risks “Wall Street” is taking and hence the economic downside if it all turns pear shaped, and the appropriate regulatory structure, unless we know what is happening.

Mindless articles such as the recent New York Times one – grossly inconsistent with facts are less than helpful. They are distracting.

One comment thought that this was algorithmic trading - someone really wanting to buy the stock - and bidding above our bid when we showed our bid. I wish that were true. If it were then if we were buying very illiquid wide spread things the bot would still be there. It is always there - even when buying defaulted debt that trades once per month. We simply ALWAYS find the bot.

Salary package includes sonic screwdriver and attractive assistant: Australian citizens only

The Australian Department of Defence is advertising for a TARDIS MANAGER.

Americans must be falling behind in defence equipment technology. They only have 67 F-22s.

Hat tip: Crikey.

Not buy and hold

Warren Buffett may – at least in part to make management comfortable – state regularly that his favourite holding period for a stock is forever. And he is a darn good buyer of shares. His name is used to promote "buy and hold".

What is less well recognised is that he is a fantastic seller. In 2000 he disposed of very large shareholdings in Fannie Mae and Freddie Mac. The stocks nearly doubled after he sold them – so for a while it looked like his timing was awry.

In 2001 – and almost without comment – he sold a huge stake in Citigroup he obtained by buying convertible notes in Salomon Brothers in the 1980s. You can find no reference to his sale in the letter – but the Citigroup convertible is in the 2000 annual and there is no reference to it in the 2001 annual. He simply converted and sold. He certainly did not advertise the fact - whereas most financial market guys would be boasting that they scored the all time high price.

The profits locked in were huge.

Buffett invested a very large proportion of Berkshire in financial shares. When the bust came he owned American Express, Wells Fargo and M&T Bank. These look like ex-post winners.

Why am I writing today? Because Warren is selling his stake in the Moodys rating agency. It looks like he is rather late. The franchise has already been seriously impaired. Moodys gave its blessed AAA to lots of things that defaulted. Indeed it seems the Moodys AAA is cursed.

Still plenty of people think that there will be a role for rating agencies - and that Moodys end position - backed by regulation - is solid.

Be warned. Buffett is a very canny buyer of equities. He is even more canny a seller.

How did the SEC get it this wrong? The judge throws out the Mark Cuban insider trading charges

I have not been a fan of the SEC – but on preliminary evidence I am forming a better opinion of Mary Schapiro than most. However as a tag-end of an era of grotesque incompetence the SEC has had the charges of insider trading it pushed against Mark Cuban thrown out of court.

The charges of insider trading against Mark Cuban were always stupid. I blogged about those charges here. I noted the (public) evidence was only that the CEO of a cash strapped company (Mamma.com) had phoned him and told him that he was cash strapped. Mark Cuban sold his shares. The SEC charged him with insider trading but did not present any evidence that he was an insider. I noted that:

To make him an insider he needs to have agreed to be an insider. He needs to have agreed with the CEO that he will take information confidentially. In other words the case hinges almost entirely on the contents of a phone call between the CEO of a failing dot.com and Mark Cuban – and the call is meant to have taken place in 2004. Nobody is going to credibly remember it. If it came to a criminal charge (which required absence of reasonable doubt) then you would have to acquit Cuban because at best this case will be two people saying “he said” and the other saying “no I did not” about a conversation years ago. As far as I know there is nothing in writing in which Mark Cuban agrees to be an insider (though something in writing is what is required). It is telling that there was no criminal charge filed with the civil charge. The criminal charge wouldn’t fly.

Well guess what – the Judge said that the SEC did not provide evidence that Mark Cuban had agreed to accept the information in confidence and hence did not provide evidence that he was an insider.

And that was obvious from the start. Unless the SEC had something in writing (which they did not) they were stuffed in this case and incompetent in bringing it.

The real issue now is how the SEC got this bad? I spot serious frauds at the rate of better than one per month – and they are rarely prosecuted. Madoff sat in front of the SEC’s face for years. However the SEC went on a wild-goose-chase against Mark Cuban on a case that was flimsy from a distance of 9000 miles (Atlanta to Sydney).

Getting trust in the financial system back is critical to economic recovery. With the SEC so far off its game that will be difficult. Mary Schapiro appears to be doing better than her predecessor. One day I hope to be blogging on SEC successes.