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).