Ducks in sewerage treatment works, drug resistance, dumb luck and investing

The day the swine flu story broke in the global press I wrote up for the blog a possible influenza hedge.  It was a stock I thought would make money – but I did not really want to win big on.  It would be nice to profit – but not because of mass influenza deaths.

Biota Holdings is an Australian small-molecule drug development company whose core asset is that they own a 7 percent royalty on all sales of Relenza.  Relenza is a distant number two influenza antiviral drug.  As explained in the original post the drug is taken through a “turbo-inhaler” which is less marketable than a tablet – but more marketable than an injection.  The difficulties taking Relenza meant that Tamiflu dominated the market. 

The story I posted was nuanced and accurate.  It was only possible to write that story because I had followed Biota before the Swine Flu outbreak and had been considering purchasing the stock anyway.  Swine Flu forced the decision.

In our quarterly client letter I wrote a follow up story which I think deserves a wider circulation. 

Firstly our clients were really lucky.  Whereas personally I purchased the stock the day the swine flu outbreak happened our clients purchased a few weeks later.  Why?  Because we could not purchase the stock for them until we received our Australian Financial Services License.  The following graph shows the advantage that they received:

 

 

The lower purchase price (dumb luck) meant the clients purchased more.  The very strong Australian dollar has meant that our US based clients have well over doubled their money. 

The luck continues

Tamiflu drug resistance (something alluded to in the original post) turned out to be the critical ingredient in the story.  It has both policy and investing implications.

In Japan, where Tamiflu is widely prescribed, the active compound (oseltamivir carboxylate) is excreted by the body (in urine) or is activated by the biological processes at the sewerage treatment works itself.  Water at and downstream from the sewerage treatment works is high in oseltamivir carboxylate.  That is really bad news because birds (especially ducks) like to bathe in the nutrient rich waters.  Those ducks are the hosts in which new influenza viruses breed – and because the water is rich in antivirals the Japanese are breeding new strains of Tamiflu resistant influenza.  This is not good news because the US government and other drug stockpiles are heavily weighted to Tamiflu – and there is a reasonable chance that the next global flu epidemic will be Tamiflu resistant.

Whilst that is not good news for the world – it is wonderful news for Relenza sales and hence our clients’ position in Biota.  And it is nothing that we anticipated.  If you told me my blog would wind up being about ducks in Japanese sewerage works I would have laughed.  From the perspective of our clients it is plain luck – but that will not stop us profiting from it.

Luck is pervasive in the investing game.  We did not figure on Tamiflu being a serious environmental pollutant.  It was just as likely that Relenza would be a pollutant.  Then, rather than showing profits we would be explaining losses to our clients.  A story about ducks in sewerage treatment works causing us losses would not sound plausible (even if true). 

Anyone with good investing results who does not admit to a dose of luck is lying.  The world is a complex place – and I would never have guessed that ducks in Japanese sewers had anything to do with our portfolio. 

The new rapid SEC

Mary Schapiro has not got great press amongst financial bloggers – however this time she beat me to the punch.

Emergent Health Corp was a heavily promoted pink-sheets biotech which (fraudulently) claimed to have a pill (yes a simple oral pill) that would stimulate the production of stem cells in adults and hence cure everything from paraplegia to heart disease to leukaemia. Here is just one of their press releases:

Emergent Health Corp. (Other OTC:EMGE.PK - News), a diversified holding corporation focused on the biotechnology sector, announces the Company has received approval from the U.S. Patent and Trademark office for their adult stem cell nutrition product Neuvitale(tm) Life Support.

An Emergent spokesperson commented, ``The Company is pleased to announce a license to market a formulation with ability to increase adult stem cells naturally from a person's own bone marrow has been allowed by the U.S. Patent and Trademark office. Now that this patent has been allowed, Emergent will seek further corporate and joint venture opportunities with firms capable of assisting entry into this untapped estimated Multi-Billion dollar market currently dominated by drugs with high costs.''

By 2004 the world market for Colony Stimulating Factor products, Neulasta(r) and Neupogen(r) marketed by Amgen was valued at $3.6 billion, a growth of 11% over 2003. That market has grown at an average annual growth rate of 16% over the previous 5 years. This is cited only as a market size barometer.

In addition to this product, the Company is actively exploring additional investment projects involved in the adult, umbilical cord, and embryonic stem cell sector to add to its growing portfolio of biotechnology ventures.

On these press releases the stock popped rising from about $1 to about $4.

The claims were outrageous of course – but you can still buy their products online.  Some of their online adverts make equally outrageous scientific claims.  Others – like this YouTube video – have a disclaimer at the end.

 

 

I tried for the last few days trying to find a borrow – any borrow in the stock.  [You need to borrow the stock so you can short sell it.]  Apparently there was a borrow on Monday but I was on holiday – and so I never managed to short the stock.  [I was planning to donate the profits to charity.]

After that I was going to write a letter to both the Food and Drug Administration and the Securities and Exchange Commission and see which organisation shut this fraud down first.  It was going to be an uncontrolled experiment to see if the SEC could live up to Mary Schapiro’s promise to be more responsive.

Alas – and this is good news for America and bad news for my favourite charity – the SEC acted fast on this one.  They just suspended the shares in EMGE. 

Whilst Mary Cox Schapiro is dragging her feet on a much bigger fraud I have shown her I got to give credit on this one.  The SEC did this quicker than they ever would under Mr Cox’s stewardship failed regime. 

The SEC has only civil powers.  EMGE rises to the level of criminal fraud.  This improvement means nothing if the prosecutor can’t back up.  And therein lies the next set of problems.

Politics makes people believe the strangest things – so let’s try make money from their stupidity

I knew I was stepping into heavily political ground when I wrote my impressions piece about Australian semi-socialised medicine.  Most responses (including emails) were reasonable – but some were so ideologically blinkered as to be perverse.

On the right there was much selective looking at data to argue that America does not produce (in aggregate) relatively poor health outcomes for the dollars spent.  You can pick individual conditions and show America is better-than or worse-than average.  But any reasonable overview of the American system will come to what I think is a non-exceptional conclusion. 

On the left there were several people who argued that pharmaceutical research done by capitalist drug companies was simply not important – citing the development of cosmetic and “me too” drugs and ignoring substantial research.  They argued real medicine is done by governments and universities – in other words good research is a socialist or semi-socialist activity.  That is simply blinkered.  One of my close friends – who has spent his adult lifetime doing cutting edge genetics research for profit (and who grew up under Chinese communism) simply responded that there are plenty of people who still believe communism is a good idea. 

Anyway one of the things that is patently obvious about America and its stock market (at least looking from Australia) is that it produces fantastically innovative companies.  American Capitalism gave us semi-conductor capital equipment producers, Google, the planes that enabled cheap commercial jet travel and mass marketed chewing gum.  More than a few of these involve some research.  Even the most cursory look at the product set of Amgen – a major drug company – would suggest that American capitalism funds some impressive drug research. 

Strange views like these exist in all countries – but the extent to which irrational right wing views are not controversial in the right and irrational left wing views are not controversial in the left is hardly a recommendation for America’s democracy.  (Americans call it polarization.)  The question is what are you going to believe: the prima-facie thing that is consistent with your ideology or your own lying eyes?

At the moment ideological belief that is inconsistent with reality is (far) more pervasive on the right as seemingly serious right wing politicians pander to Rush Limbaugh’s lack of nuance or to anti-scientific creeds such as creationism.  But it is not always going to be that way – and some of the responses to my post suggest that there is a latent left wing Limbaughism too.

But this is just tearing wings off butterflies.  There are plenty of stupid and/or ideologically blinkered people out there.  Pointing them out has about the same level of charm (and general interest) as making fun of “creation scientists”. 

I write an investment blog – and I have no reason to be interested in where commentators in the blogosphere are demonstrably wrong because they argue from their ideology rather than observable facts.  I have a really big interest – a money making interest – in where people are wrong in markets because they rationalize from ideology rather than observable facts.  These things happen – for many years market driven ideologues thought that the securitised mortgage market was fine because it was done by private sector participants (and it mostly dealt in mortgages that Fannie Mae and Freddie Mac were prohibited from dealing in).  They were wrong.  Anyone who hung out with a half dozen mortgage brokers and saw the trash they were underwriting could have (and should have) worked out that this was a disaster.  Ideology trumped facts on the ground.  And it gave some stupendous money making ideas.  People made hundreds of percent returns on their money shorting the AAA strips of CDO squared securitisations and other high-finance dross.  I know someone that made billions (yes billions) of dollars betting that subprime lending would end in a crisis – and they only had to risk tens of millions of dollars to make that money.  Stupid ideology gave huge profit potential. That stupid ideology came from the right because at the moment there is (much) more stupid ideology on the right – but again it was not always that way and will not always remain that way.

So – here I am begging my readers.  Much as I like reading about creationist astronomy and postmodernism and the Sokal Hoax and other people made stupid by their ideological blinkers - I would prefer find market sensitive stupidity.  If people can reply with ideas and the easily observable facts that prove them wrong I would be thrilled.  Emails acceptable.  But please no argument based on your ideology versus their ideology.  I am only interested in argument which is “their ideology versus readily testable fact” and then I am only interested if we can make money out of it.

 

John

PS.  Don’t mention Zion Oil and Gas.  I have already covered that one.

Hoisted from the archives – my old post on Freshwater and Saltwater macroeconomic theory

Long before Paul Krugman elevated the central schism in macroeconomics to the front page I wrote about it on this blog.

My old post is reprinted below (with a few trivial modifications to make it more readable than the original):

Freshwater and Saltwater:  macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post…

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molonglo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays (whereas I should have been short the credit sensitive banks). I have detailed that mistake here. Bill Gross made a similar mistake declaring (early) the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was wrong in good company.

Now the subject of freshwater, saltwater and other macroeconomic elixirs is the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton

PS.  I know that the inflation junkies are still predicting hyper-inflation – but they were also predicting it in January when I wrote the original post.  The Freshwater guys are still wrong. Will the backers of the Freshwater school please put out a testable timetable?

PPS.  A reasonable summary of the issues I lived can be found in Justin Fox’s book.  Whether Krugman should have referenced Fox in his magazine article is an open question – but I think Fox’s summary is right… Krugman lived the issues in the book and did not need Justin Fox to explain them to him…

Vested self interest and the future of Fannie Mae and Freddie Mac

Fannie Mae and Freddie Mac take credit risk and interest rate risk.

They take credit risk primarily by guaranteeing mortgages.

They take interest rate risk primarily by owning mortgages and financing them on their own balance sheet.  They also trade the interest rate risk of that book using derivatives.

The anti-GSE lobby always asserted (and I once erroneously believed) that Fannie and Freddie Mac would come to grief on their interest rate risk.  Taking interest rate risk is what the once-extensive anti-GSE lobby meant by charter creep.

Well the anti-GSE lobby were wrong.  So was I.  Fannie and Freddie did not blow up on interest rate risk – they blew up on credit risk.  Mainly they blew up on credit risk from non-charter mortgages but they still have had no noticeable interest rate problems during this cycle.

The Anti-GSE lobby always had an agenda

Wall Street always hated Fannie and Freddie taking interest rate risk – it encroached on the profitability of Wall Street trading desks.  Trading interest rate risk is the core business of Wall Street trading desks – and they hated having GSEs (with funding advantages) crowding them out of their own game.

But Wall Street loved Fannie and Freddie taking credit risk – that meant that Wall Street could splice and dice mortgages all they like – and know that eventually Uncle Sam will pick up any credit losses.

So they always pushed for limits on the interest rate risk that the GSEs could take.  I never heard FM-Watch or other anti-GSE lobbyists arguing for limits on GSE credit risk acceptance.

When the anti-GSE lobby now say “I told you so” they are lying.  They said the GSEs would blow up on interest rate risk and they were wrong – but they are falsely claiming intellectual credit anyway.  It helps their lobbying.

So how do the proposed reforms of Fannie and Freddie look?

All public proposals for GSE reform have the same feature.  They all allow Fannie and Freddie (or their replacement entities) to stay in the credit risk business by guaranteeing mortgages – but they insist that Fannie and Freddie shrink their balance sheet – and hence take less interest rate risk.

In other words they leave all the credit risk with the GSE – solving nothing from a taxpayer perspective and give all the interest rate carry (and most the revenue) to investment banks.  They do nothing to solve the problems that caused the GSEs to fail. 

That is also the structure of the conservatorship agreement by Hank Paulson forced the GSEs to sign – an agreement constructed by the staff of Morgan Stanley.  The agreement gave Wall Street precisely what it wanted – which is not surprising because it was drafted by Wall Street investment banks. 

The Mortgage Bankers’ Association proposal is even more egregious – but that is the subject for another post.  Even the Government Audit Office report leans heavily towards the wishes of investment bankers.  (You would think they would be better than that – but it seems they are only as good as the people lobbying them.) 

So here is a hope for the Obama administration.  Be very sceptical of the the vested self-interest behind anyone making GSE proposals.  [Whilst that includes me I am just shooting from the sidelines.  Investment bankers drew up the conservatorship agreement in the interest of investment bankers.  That sort of power should not go unchecked in America.]   

Fannie Mae and Freddie Mac – closing the modelling sequence

The last post – which was incredibly difficult to write – received remarkably little comment – and almost no feedback. So I am going to close the modelling sequence early – and write a few posts about the politics of Fannie Mae and Freddie Mac as standalones. Almost all the proposals for “reform” seem to leave most of the credit risks with the government and give much benefit to Wall Street bankers. That includes the original proposals implicit when Paulson – the once King of Wall Street – put them into conservatorship. I will later expose those for the vacuous positions that they are. I want to write the politics sequence so you do not have to have closely read the modelling sequence – because I know these will appeal to different audiences.

But for now I will note that most the well-informed comment has indicated that I have underplayed the role that tax losses have played in putting Fannie and Freddie into the position they are. Certainty as to their future will enable them to write back the charges against tax assets they have taken. 18 months of profitability (which they will have) plus some certainty to the future will allow approximately 30 plus billion dollar write backs at both GSEs. That will leave the GSEs with positive net worth (and able to repay government loans) in time for the 2012 election. I will leave that to the politics sequence.

I said in the first post that I will close with a comment that was once left on my blog by “Bondinvestor”. This was the only comment I have ever censored because it stole my thunder… here it is… [with annotations in square brackets and blue colour]. I pleaded on the blog for Bondinvestor to contact me – but with not much luck. Bondinvestor summarises my arguments quite well – though I think the same applies to Fannie Mae – albeit with less force.

You should take a deeper look at FRE. it was a very well run company before the crisis - and not just on the portfolio side. [I was – well before Bondinvestor left this comment.]

Look at their credit statistics. the 90+ delinquencies are high relative to history, but far below the rest of the industry - as well as Fannie Mae. [I noted this in Part III.]

The tragedy at Freddie is that they purchased non-agency AAA MBS in an attempt to meet their housing sub-goals. [I noted in Part II that the losses came primarily from the Private Label Securities.] Their calculus was that the inherent subordination in the AAA's would protect them in a credit Armageddon. [Well we got credit Armageddon and the Private Label Securities business did cause huge losses for the GSEs.]

What is fascinating about FRE is that the jury is still out on what the actual realized losses in their non-agency book will be. The AAA private label pass throughs that the agencies bought were specially designed for them. The balances were all conforming; the pools had lower CA/FL concentration than the rest of the non-agency universe; and - most interestingly - the loans underlying the GSE's AAA's were segmented from the AAA's that were sold into the public market, though they shared the same subordinate tranches. what this means is that catastrophic losses in the Type II bonds do not necessarily imply catastrophic losses in the Type I bonds (the GSE-eligible AAA's). [Analysing this was the point of Part IX. They will incur losses – just nothing like as bad as they provided for.]

If you go look at remit reports, you'll see that the delinquencies underlying the agency-eligible bonds are much lower than the DQ's underlying the non-agency bonds. [Actually I have done so – and whilst the DQs are lower in the agency-eligible pools they are not much lower. The biggest advantage that the agency eligible pools have going for them is that they retain far more excess collateral against their delinquencies.]

Now, part of the problem is that the atrocious performance of the non-agency pools will eat up the subordinate tranches, thereby depriving the GSE-bonds of their fair share of the enhancement. [They have almost entirely done so in the series I analysed in Part IX] but, given the relative performance of the loans underlying the GSE bonds, it may not matter. [It will matter with respect to the series that I have looked at – but the excess protection in the agency-eligble pools means that the GSE losses will be under half the losses incurred by the AAA strips of the non-agency eligible pools – in many cases less than 15 percent of the normal AAA losses.]

Anyway, all this is a very long winded way of saying that the actual realized losses in Freddie's $150B portfolio of private label MBS may not approach anything like the huge mark they have taken on this book (and which destroyed their capital base in the early innings of the credit cycle). [Freddie thinks about 30 billion will reverse as described in Part IX – I think it will be less – but I am having a very sophisticated conversation with one reader who thinks it will be more – and provides modelling to prove his points… I think I could be twisted to agree with him – and will put up a technical post if we (jointly) ever get around to writing it…]

I know folks inside FRE who think that the "shadow equity" that comes back on the balance sheet as the PLS portfolio pays down is on the order of $70B. that is more than enough to retire the convertible preferred note the government took as part of the conservatorship. [I know no such folks. I worked this out on my own. But I think the shadow equity is closer to 50 billion – say 25 billion that will reverse on the private label securities and the other temporary impairment plus about 30 billion in tax losses but less the 10 billion or so more reserves I think they need to take over time on the traditional business.]

Now, none of this is to say the losses on the guaranty book won't be large. but the company discloses enough information to come up with a reasonable estimate of what they could be. You just have to look at the 06/07 vintage curves and make a judgment about how long it will take those books to season. the realized cumulative losses will most likely be somewhere between $30 and $50B. they already have a loan loss reserve of $22B. so they have some wood to chop, but it's not an egregious amount. [Well I did that modelling in Part VI. I agree with the numbers Bondinvestor comes up with – actually I think the end losses will be less.]

A much bigger issue for the company than the actual credit losses is the terms of the senior convertible preferred. If the coupon is 10% if paid in cash, and 12% if they take the PIK option. That's $5B a year after tax and it wipes out all of the normalized profits of the enterprise. it's a far more egregious rate than any of the other pieces of paper the government bought in the midst of the crisis, and it was put there by the bush admin to prevent the GSE's from organically rebuilding their capital bases. [Again I agree – the object of the conservatorship terms were to wipe Fannie and Freddie out – the takeover was political in execution. However the current income of Fannie and Freddie is way above trend – and this will not be a problem if the high revenue is sustained.]

FRE preferreds trade at 1-3 cents on the dollar. they are basically warrants on the ability of the company to one day retire the government note. with a payoff function of 100x, i think it's a speculation worth taking. [They trade higher now – but I was buying at these prices.]

In summary – working through my models I will be wrong if

(a) the running income halves

(b) the end losses are higher than I thought and

(c) the “temporary impairments” – particularly at Freddie Mac turn out to be “other than temporary”.

On those I am most insecure on the running income as I discussed in Part V – but the running income is already running far faster than I anticipated when originally buying these securities.

The GSE takeover will wind up costing government surprisingly little. I think it will wind up being profitable. The future of the GSEs is not determined by their insolvency. That I think, time will take care of. It is determined by politics.

I will do a political series later – and they will have a wider audience. Wall Street wants to carve the GSE business up for the benefit of Goldman Sachs et al. The Wall Street political lobby is very effective and the terms of the GSE conservatorship prevent the GSEs from lobbying on their own behalf – which means that unless we are careful the Wall Street lobby will get what Wall Street wants. But that is for future political debate – and the Obama administration has sensibly put off decisions as to the GSE future until next year – and ideally they will put it off until even later.

I hope I have achieved what I wanted to with this series – which is to stop the model-free GSE bashing that had become the popular line of thought of the press and the blogosphere. Later I hope to take on the vested self interest behind that GSE bashing – showing them (especially the Mortgage Bankers Association) for the egregious self-interested participants that they are.

Betting on – or against – Obama hatred

I run an investment business – and my blog is about investing.  Sometimes (quite often) investing requires that you have a dispassionate look at politics, political trends and political decisions – even if those trends and decisions are anathema to you.

This is one of those times.

In March the US economy was in dire risk.  Everyone who sold discretionary consumer products – especially high value discretionary consumer products – was watching their business implode about them.  Well not everyone – but almost everyone.

One sector was having a rollicking boom – an off-the-scale big boom.  It was recreational handguns.

A large number of Americans allowed themselves to be convinced that Obama was going to take their guns away.  Or maybe they were convinced that socialists were taking over the country and that you needed to protect yourself.  They may have even been convinced that Nazis were taking over the company (evidenced by eugenics policies under the Trojan horse of nationalised health care).  Whatever… they bought guns.  Lots of them.  Here is a presentation from the Ruger AGM…

(Some corrections – the sales are probably on first quarter 2009 running at about 1.5 billion at the moment… this boom is MUCH bigger than show in in this graph). 

I do not need to tell you a billion dollars (the current projected 2009 sales) represents a lot of handguns.  Its up 250 percent [see correction – but about 400 percent] since 2003.  Very few consumer products (that are not made by Apple) can claim that.

The Obama-hatred inspired boom in handguns was so large that manufacturers simply could not keep up and handguns had to be obtained on order.  The companies had exploding forward order books.  As Smith Wesson said in a press release dated 22 June…

Our firearms backlog continued to increase dramatically during the quarter, and reached its peak at $268 million dollars by the end of April. That level is $218 million dollars higher than the same quarter one year ago.

More generally, Smith & Wesson deserves special mention.  They have taken as their marketing guide the success of Harley Davidson – a company producing marginally inferior (but iconic) products and turned it into a mass-market product for wanting to rebel (and recapture youth) middle-aged baby boomers.  What is more they have done so with some success – as evidenced by their shoot-the-lights-out record sales this quarter. 

Dispassionately if you thought Obama hatred of the most extreme ilk was going to continue to grow like topsy you would buy Smith and Wesson and its ilk – and become a gun seller.   As a committed Liberal I might not like the second amendment and I might like the second amendment supporters even less – but – we owe a duty to our clients to make money – and we might even do it owning the shares of a gun manufacturer.

Fortunately though that is not the decision we have taken.  I am not sure I would be comfortable being a gun seller – and some of my clients might also have strong views.  We prefer to short this…

The proof of Obama is there to see.  Obama is (despite the protestations of Rush Limbaugh and his ilk) turning out to be a middle-of-the-road centrist.  [Strong Liberals wanted change they could believe in…  Smith & Wesson just wanted to sell guns.] 

And they have.  Smith and Wesson sales were good but their forward order book took a dive.  To quote Wednesday’s press release

Our firearms backlog was $177.5 million at the end of the first quarter. Cancellations reduced backlog by approximately 10% during the quarter. It is important to note that our backlog always represents product that has been ordered but not yet shipped. As a result, it is possible that portions of the backlog could be cancelled if demand should suddenly drop.

The warning about the backlog not being binding is new – and it is clear from the new disclosure that they are having massive problems during this quarter with order cancellation. 

The backlog dropped from $268 million to $178 million – a drop of 90 million.  Ten percent of that (say $27 million) was order cancellation – but a net $63 million of sales came from the backlog.  Total sales were 102 million – and less than 100 million in firearms.  The rate at which Americans are placing orders for new Smith and Wesson handguns is collapsing. 

The company did not tell us the current forward order book.  At that rate of collapse what they are facing is a disaster.

Whether that says anything about the size and intensity of belief of the Rush Limbaugh right – well I will leave that for my readers to discern.  We just want to make money for our clients – so we are short Smith & Wesson. 

Modelling Fannie Mae and Freddie Mac - Part IX

I am sorry for the couple of weeks delay in publishing the continuation of this series.  It was caused at least in part by my collarbone* and in part by just how difficult the next two posts have been to write. 

In this series I have shown that the biggest source of losses (actually realised) so far at Fannie and Freddie have been private label securities (notably senior tranches of subprime and alt-a securitisations).  The traditional business (insuring well secured and well documented qualifying mortgages ) has caused very few losses thus far (though substantial provisions have been taken). 

The dross in other words was in the private label securities. 

Now I stated in Part II that whilst Fannie and Freddie have made their biggest losses in private label securities they happen (perhaps by dint of better underwriting) to have the better end of the worst part of the mortgage market.  The next couple of posts aim to explore that statement and measure it against the provisions which Fannie (and particularly Freddie) have taken thus far.  I am conducting a robustness check on Part II and hence a check on the robustness of the starting balance sheet used in the model presented in Part VI. 

Fannie’s statements about better underwriting of private label securities

Fannie Mae has publicly argued that whilst they have losses on private label mortgage securities their losses are far less severe than market.  I have not done the work on individual securitisations at Fannie Mae to back that statement – but I will reproduce a graph from Fannie’s credit supplement comparing Fannie owned Alt-A private label securities with market private label securities.

 

. 

 

Note that the cumulative defaults of the pools on which Fannie Mae owns the AAA strips are running just under half the cumulative defaults of the market average Alt-A securitisation.  

They appear to have this better result without huge differences in the indicators by which they have selected the loans.  From the same page in the supplement here is a comparison of Fannie Alt-A credit characteristics with market Alt-A credit characteristics. 

 

The biggest difference is that they did fewer adjustable rate and negative amortizing loans – that is they purchased fewer loans with payment shock (when payments reset). 

I do not have any real analysis of how Fannie managed to pick Alt-A loans that were so much better than the market. I would welcome informed comment.  But the obvious place to look is at Fannies’ relationship with Indy Mac.  Fannie had a close (and costly) relationship with Indy Mac – and the above data suggests that Fannie was allowed to cherry-pick Indy Mac’s book.

That said, the close relationship between Fannie Mae and Indy Mac (which seemingly allowed cherry-picking of Indy Mac’s book) did not give Fannie good mortgages, just a better calibre of dross.

Freddie Mac’s better than average class of dross

Fannie claim to have better-than-average Alt-A private label securities.  Their mark-to-market provisions have however been lower than Freddie Mac – and I have not compared individual securitisations to Fannie’s marks as reported in their accounts.

I have made that comparison for Freddie Mac.  Freddie Mac has taken very large marks in their accounts for private label securities (and by the end of the first quarter of 2008 Freddie had reported larger losses than Fannie based primarily on these marks). 

Freddie do however have a (legitimate) claim for better-than-average selection of (bad) AAA subprime securitisations.  There will be write-backs based on this. 

Let me however introduce you to the Long Beach Mortgage 2006-11 (subprime) securitisation. 

Long Beach Mortgage was the subprime mortgage company associated with Washington Mutual.  The loans were way too risky to put on Washington Mutual’s balance sheet – and the performance of these loans is many times as bad as the performance of Washington Mutual’s own balance sheet. 

Moreover, the later securitisations were done in the subprime bubble the worse they performed.  Pools that were originated late in 2006 (such as 2006-11) behave considerably worse than pools that were originated even as late as early 2006.  There is a reason for this.  If you were a borrower who borrowed in 2005 and you could not repay your mortgage in 2006 you did not default.  Instead you simply took another mortgage (often taking cash out on refinance) and repaid the old mortgages.  Early 2004 and 2005 pools showed few losses for some time even though the underwriting standards were atrocious.  The reason was that the bad loans rolled into later securitisations.  The cynics (correctly) observed that “a rolling loan gathers no loss”.  The late 2006 pools are truly atrocious because they contain not only the bad loans originated in late 2006 but also refinances of the bad loans originated in 2004 and 2005.  The ability to refinance a bad loan just ended – with the result that the late 2006 vintage is especially atrocious.

So when we look at subprime mortgages originated by Long Beach Mortgage in late 2006 we are looking at amongst the worst credit originated during the whole bubble. 

Freddie Mac took a large exposure ($408 million I gather) to AAA strips backed by this appalling pool of mortgages.  They will lose money on that – and have taken provision.  But surprisingly they will not lose quite as much as you would at first glance think – because - despite playing in the sewer - Freddie Mac took some measures to ensure that they could at least keep their nose above the sludge. 

You will find the original offering documents for the 2006-11 series here.  Much of the rest of this post is dependent on unusual features in those offering documents.  So here goes. 

Most mortgage securitisations (or credit card securitisations or the like) had a single pool of mortgages (or credit cards) and tranched them into many strips (often 15 or more).  Credit defaults were attributed to each strip in order.  So if there were a small number of defaults junior tranches (originally rated maybe BB) would wear those defaults.  If there were more defaults mezzanine tranches (often originally rated A) would bear those defaults.  Only if there were very large defaults would the senior tranches (originally rated AAA) suffer.

Often AAA tranches had 15 percent of protection – meaning losses had to be 15 percent of original outstanding before the senior tranches lost a penny.  It was argued that it was inconceivable that say 30 percent of mortgages in a pool would default.  And it was inconceivable that the loss given default (severity) would be more than 50 percent – so (it was argued) it was doubly inconceivable that there would be enough losses to affect the AAA securitisations.

Alas we now know that to be false.  Many AAA strips are seriously impaired as defaults and severity have been substantially higher than what was considered even conceivable just a few years ago.

The long beach securitisation(s) look just like this except for one thing.  Instead of having one underlying pool of mortgages they have two underlying pools – Group 1 and Group 2.  These individually support their own AAA strips but collectively support mezzanine and junior strips.  Now this strange structure was done for a reason – the reason being that the GSEs (notably Freddie Mac) wanted to ensure that they had more protection than the average subprime pool investor.  These loans were real dross – but they wanted the better end of the dross.  This is explained in the (2006-11) prospectus.

The trust will acquire a pool of first and second lien, adjustable-rate and fixed-rate residential mortgage loans which will be divided into two loan groups, Loan Group I and Loan Group II. Loan Group I will consist of first and second lien, adjustable-rate and fixed-rate mortgage loans with principal balances that conform to Fannie Mae and Freddie Mac loan limits and Loan Group II will consist of first and second lien, adjustable-rate and fixed-rate mortgage loans with principal balances that may or may not conform to Fannie Mae and Freddie Mac loan limits.

Now don’t think the loans in Group 1 conform to Freddie’s normal loan standards.  They do not.  But they are better than the Group 2 loans.  We know this in a couple of ways – the most important is that the average original principal balance for the Group 1 loans is $185,000 versus $273,000 for the Group 2 loans.  Also the concentration in California is lower for group 1 loans (28 percent versus 54 percent). 

Now I started this with a (hyper bullish) view that whilst the Mezzanine strips of various loans might be trashed, the Group 1 loans – being pre-selected might be OK even though the Group 2 loans (the publicly traded high rated parts of the securitisation) might be very bad.  Alas that is not the case.  Indeed the surviving Group 1 loans are very bad (though not as bad as the Group 2 loans).   

Anyway here is the cumulative distributions and realized losses for the various tranches of the 2006-11 securitisation – these distributions and losses covering both groups of loans.  Note that this is a very-late-cycle securitisation and would have high expected losses as a percent of original outstanding…

This data comes from a Deutsche Bank (as trustee) monthly statement to holders of securitisation paper.  You can find the trustee report here…

The way to read this is that the mezzanine strips have been almost entirely wiped out – and the losses are coming very close to imposing on the senior strips.  For example the M4 strip had an original face-value of $24.75 million.  That is how much investors paid for that interest in the mortgage pool.  They have on that investment received $2.344 million in interest but their principal has now been wiped out.  They are gone – and there is no recovery.  However so far the losses have not been big enough to actually reduce the principal owing to the A strips.  The 1A strip (which I gather is owned by Freddie Mac and is backed by the better mortgages) was originally just over $408.0 million.  They have received all interest owning, 6.8 million of scheduled principal repayments and $143.8 million of unscheduled principal.  The are still owed $264.3 million of the 408 million invested.  On the money they have received back (in cash) they can take no losses – the money is in the bank.

The collected Group 2A strips originally invested (332.1+136.4+243.2+91.5=) 803.2 million of which ( 53.0+136.4+243.2+91.5= ) 524.1 million remains outstanding…

We also know how many loans were originally in each group and how many remain from this table…

 

And now we see the big advantage of Group 1 over Group 2.  Group 1 has 326.2 million in loans outstanding backing 264.3 million in Group 1A certificates outstanding.   Group 1 can absorb mortgage losses of $61.9 million before Freddie Mac (as the AAA strip owner) loses a penny. 

By contrast Group 2 has 534.2 million of principal balance outstanding supporting 524.1 million in AAA strips.  They can only lose a further 10.1 million before the AAA takes cash losses. 

The better-than-pool collateral backing the Group 1 certificates has helped Freddie Mac because even now – with huge losses already incurred – Freddie has taken no cash losses and still has 23 percent excess collateral.  They still have considerable protection. 

I was hoping to stop this post just here - but 

Note that Freddie still has considerable extra collateral backing their exposure to one of the junkiest pools in the whole subprime mortgage bubble.  I was hoping that excess collateral was enough – and that Freddie might – through dint of clever structures and preselecting the best loans in a pile of dross be able to get through the whole subprime thing with only mark-to-market losses that would soon reverse.  In other words I was hoping for a hyper-bullish reversal of most of the losses discussed in Part II of this series… 

Alas the remaining loans are truly atrocious and 23 percent excess collateral is not enough.  I know it is unlikely to most readers to assume you could pick a bunch of loans have more than 50 percent default and 50 percent loss given default – something that would be necessary to impair Freddie’s Group 1 AAA certificates.  But – this is a late 2006 Long Beach securitisation.  Unlikely as it might have seemed just a few years ago the losses will be much worse than that.  Here is the delinquency data for the Group 1 loans.

 

 

This delinquency is almost 20 times as high as Freddie Mac’s conventional (non-credit enhanced) mortgage book.  Different pools of mortgages can have a delinquency and default difference by a factor of 20 depending on underwriting – and unfortunately the underwriting at Long Beach mortgage was bad – even for the Group 1 loans (which were pre-selected to be better). 

There is 12 percent (and flat) early stage delinquency, 16 percent (and rising) late stage delinquency, 13 percent (and falling) foreclosure and 6 percent (and flat) bankruptcy and REO. That is 47 percent problematic loans.

I have only educated guesses as to how many of these will eventually default – but an upper end assumption is that end default should be 1.2 times current delinquency. Not all the early stage delinquents will default of course – but there will be new delinquency and some non-delinquent loans will eventually default.  Anyway a reasonable (though high-end) guess is that 56 percent of outstanding principal will eventually default.

Still 56 percent default would not impair us dramatically if loss severity were only 50 percent.  After all we still have considerable excess collateral left on this loan pool before the AAA securitisation tranches are impaired.  Unfortunately severity is running MUCH higher than 50 percent.  Here is the severity for both the Group 1 and Group 2 loans.

 

 

Note severity is running about 75 percent.  That is implausibly high and suggests very bad loan servicing.  [The severity data is the subject of the next post.]

Still this suggests that the end loss from the Group 1 pool to come is very high – 56 percent default and 75 percent severity – suggesting 42 percent of the remaining pool will be lost.

I am not going to go through this but it is substantially worse for the Group 2 loans (the ones Freddie rejected).  The delinquency for Group 2 loans is even higher.

What this means for Freddie

Remember above I showed that there were 326.2 million in Group 1 left outstanding.  We think the loss on this will be 42 percent or 137.0 million.  There is however 61.9 million in excess collateral protecting the AAA certificates.  That will all be lost and 75.1 million in losses (137.0-61.9) will be visited on Freddie Mac. 

Freddie Mac has a $264.3 million outstanding balance – they will lose (75.1/264.3=) 28.4 percent of the outstanding balance.  The structure protected them – Group 2 loans will have much bigger losses – but losing 28.4 percent of the outstanding balance is still atrocious.  Its a better class of dross.

Generalising the 2006-11 series

I have fiddled with a lot of Freddie Mac securitisations in the course of writing this series.  As a rule Freddie securitisations had structural features which meant that Freddie Mac losses were smaller than market losses but are large nonetheless.

However the 2006-11 series is a particularly bad series (subprime, late in the boom).  Most series have losses for Freddie below 25 percent of outstanding balances remaining as of June 30.  Any mark worse than that and they are going to write back the excess over time.

Here are the marks as reported in the last 10Q:

 

Note the amortised cost of the subprime exposure is 63.9 billion and the gross unrealised loss is 24 billion.  That is a 37.5 percent mark.  After careful looking through securitisations I cannot find a single securitisation where I think Freddie will lose above 30 percent – and 25 percent is more common.  On that count there is 8 billion which should run back through the accounts as they have marked-to-market and the losses will be not as bad as the market. 

The model I presented in Part VI calculated losses and income from the current position of Freddie’s balance sheet.  However here we appear to have found another 8 billion improvement on Freddie’s initial balance sheet – that is the real position of Freddie Mac is 8 billion better than I modelled in Part VI.  

Freddie Mac reckon that about 10.4 billion of the losses they have booked are “temporary impairment” and should reverse.  It is plausible – but my 8 billion is a lower number. 

Cumulatively Freddie’s accounts show about 31 billion of temporary impairment – losses that they think will reverse.  Outside subprime I have made no effort to test that number – but it seems high to me.  Moreover some of this impairment seems to come back through the currently inflated revenue line and I do not want to double count this benefit.

Summary

I noted in Part II that Fannie and Freddie had incurred their major losses to date on their Private Label Securities.  However I also asserted that Fannie and Freddie picked private label securities that were better than market – that is confirmed and alas it did not stop them from incurring very large losses.

A careful look at some bad securitisations suggest that those losses are more than full provided for (and hence Freddie in particular is slightly more solvent than this series suggests). 

 

 

John

 

*I thank the many people who have wished me well, inquired about my broken collarbone and – in some cases – asked how my treatment fitted in with my analysis of Australian socialised medicine.  The short answer is that I am going well.  My break is one of the 90 percent that current practice suggests do not require an surgical pinning.  So I have put my arm in a sling, taken huge doses of painkillers and waited for the bone to mend.  The painkillers are not pleasant.  There are lots of side-effects listed on Wikipedia including elation, hallucinations, itchiness, constipation, and excessive sweating.  I seem to have all the unpleasant side-effects and none of the pleasant ones.  I cannot fathom why people take these drugs recreationally.  The painkillers are however better than the pain – which was overwhelming. 

I have yet to reduce the painkiller doses – but I am expecting the side-effects to be unpleasant when I do so.  I will write this up later for those that are interested – especially how my experience fits in with my views on socialised medicine.

Sorry – no posting for a while…

I broke my collarbone in a bicycle crash.

Fannie and Freddie series to be continued…

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

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

 

 

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

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

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