Weekend edition: the somewhat cooler Hempton

My cousin got the movie star looks and the saxophone. I got the penchant for reading accounts of banks. I think he got the better deal!

I suppose he got the girls too! And he got the MySpace page with the cool jazz soundtrack.

For my NYC readers - he is back in NY -

22 Sep 2008, 07:30 PM
183 W10th st @7th Ave, New York, New York
Cost : $20 incl. a drink!

Foreigners selling Fannie and Freddie debt

I wrote here about what seemed to be the irrationally wide spread on Fannie and Freddie debt. We are after the Paulson plan. The US Government has promised it stands behind these entities. But the spreads still widen.

Widening spreads will cause the end - because Fannie and Freddie need to borrow humungous piles of money.

Now Naked Capitalism has a nice post on foreigners selling Fannie and Freddie debt. That seems irrational to me - but it is still happening - and that is not good news for the GSEs.

J

Estonians trash their flash cars: can't make the lease payments

The most read post ever on this blog was "Hookers that cost too much, flash German cars and insolvent banks".

In it I predicted a future for the Baltic States where the middle class rioted and Swedbank (the Swedish bank most responsible for funding the bubble) was trashed either by depreciation caused default or just by default.

Anyway I love this story. An insurance company in Estonia is having troubles with customers trashing their flash cars because they can't make the lease payments.

It gets worse and worse and worse from here.



J

PS. I mentioned the geopolitics in the first post on this subject... I said I was "loudly calling the likely collapse of a politically sensitive country". Well now the Estonian press is actively speculating about a Russian takeover. I think it is unlikely - but do not forget the Bronze Soldier.

For those with a real interest I know enough history to be dangerous. My version comes from the perspective of some Jewish relatives who were holocaust survivors. My relatives saw the Baltic States as containing particularly enthusiastic Nazis. (They tend to site Lithuania over the others but I think that was bitter experience. Lithuania had a gruesomely effective holocaust). Whether the Balts were more enthusiastic Nazis than some other Europeans is something I have no real knowledge of. Indeed the initial Russian-Nazi treaties gave Lithuania to the Germans but the Lithuanians refused to participate in the invasion of Poland and passed to Rusian influence until the Nazis reinvaded...

The Russians still look on the march into the Baltic States as a liberation from Nazism. They revere their Bronze Soldier. Many Baltic people see the same Bronze Soldier as a symbol of Russian oppression.

When the Estonians moved the statute there were deadly riots. These wounds are still open.

My Jewish relatives however wound up living in an apartment building in Bondi Australia one floor above some post-war Lithuanian immigrants. They became firm friends . And both could see the other's point of view...

Article in Portfolio magazine on British banking

I haven't written much on UK banking - an article about Barclays, one on Alliance and Leicester and one on Northern Rock.

But I got quoted in this neat and accurate story in Portfolio magazine.

All I noted was that the UK had taken Maggie's philosophy to heart and decided that if financial institutions didn't have much capital the market wouldn't deal with them. The result is that UK institutions got to run with much less capital than their American counterparts and that left them vulnerable.

That is clearly true. But the journo found a better story about why wholesale financing arrangements shouldn't be regulated... that lovely cliche about "consenting adults".

Hey you know what happens to "consenting adults"...

I thought you did...

Things that make you go hmmm...

Fannie Mae conducted one of its regular "benchmark note" auctions today. Here is the relatively non-descript Reuters report.

The spread over Treasuries was 122bps.

In the old days when Fannie debt was explicitly not backed by Treasury it was about 60bps or less.

The US Government has made it clear that it backs Fannie - so this extra-wide spread is surprising...

Unless people no longer trust the US Government.




John

PS. The investment implications are not good. The only plausible buy case for Fannie at the moment is that its not much to pay for a franchise with a US Government guarantee. If nobody trusts the guarantee there is no franchise...

The crudest of models for Fannie Mae cumulative losses – (Fannie Mae Part III)

As explained in the “modelling post” there is very good reason why you cannot sensibly estimate prime mortgage losses. They are getting worse at an increasing rate.

I didn’t want to make it up. So I asked my readers for guidance. Nobody much helped me – but several people pointed to Jamie Dimon’s various statements on the subject. Those statements come down to Dimon’s broad guess that losses will triple.

We know the trends look awful.

But I have a model. Its crude – but in the face of radical uncertainty it is about the best I can do. So I will present it.

Below is a chart of the type that most thrill me as a bank analyst. It’s a cumulative loss chart as presented in Fannie’s last quarterly results.

What this chart shows is the cumulative loss on loans versus the time the loan was originated. It’s a sort-of-generalisation of the securitisation cum-loss charts with which I am so familiar.

This chart contains several trends that are representative of the whole mortgage industry. The 2007 pools are radically worse than the 2006 pools which are in turn radically worse than the 2005 pool. The 2004 pool is OK but turning a little sour at the edge…

I have a pet theory as to why the 2007 pools are so much worse than 2006. Its not that the lending was any more stupid in 2007 or that property prices had gone one step too far. It was that there were many bad loans made in all years after 2002 however the bad loans didn’t default – they were refinanced. They all thus wound up in the later pools and hence the later pools preferentially contained the bad loans. They are thus awful.

Anyway Fannie Mae doesn’t give us this data in tabular form – but here is my simple model.

Data:

• The 2006 pool is currently behaving about 3 times worse than the 2000 pool.
• The 2007 pool is currently behaving about 6 times worse than the 2000 pool
• The rate of deterioration of prime delinquency is increasing
• Fannie Mae took credit risk on 615 billion of mortgages in 2006 and 746 billion of mortgages in 2007. We do not know how many of those mortgages are still outstanding – but total mortgages outstanding are a bit over 3 trillion.
• The baseline 2005 pool wound up with cumulative loss of 1.25% plus a trivial amount in the out-years.

Assumptions

• That the outstanding mortgages from 2006 are 450 billion reflecting some repayment to date. (This is a good educated guess – if Fannie publishes the data somewhere I have no memory of it…)
• That the outstanding mortgages from 2007 are 650 billion reflecting some repayment to date (another educated guess…)
• That the relative performance of the 2006 and 2007 pool vis the 2000 pool remains the same – which means if it starts 3 times worse it ends 3 times worse.

Calculations

• The 450 billion outstanding from 2006 will wind up a further 2 times 1.25% worse than the baseline 2000 year. That is 3 percent of 450 billion – say 15 billion.
• The 650 billion outstanding from the 2007 year will wind up a further 5*1.25 worse than the baseline 2000 year. That is 7.5% of 650 billion – or 49 billion.
• That totals 64 billion.

Some notes on the model

There will be a few losses from 2005 and other years – but they are small.

The numbers could be MUCH worse than this – because as I have noted the rate of deterioration is accelerating – which tends to indicate much worse.

They could also be worse than this if the mortgage insurers who are the frontline protection on the high LTV loans fail. [Mortgage insurance is already built into the base line losses.]

There are also a few things that Fannie is currently doing in loan modifications that look like loss deferral and that could further mean my numbers are conservative.

Against this, losses could be better than these calculations because there could be a pig-through-the-python effect in the conventional mortgage market just as I believe there has been in subprime. [Indeed there is some evidence that the 2007 pool is so bad precisely because a lot of bad loans did one last refinance into Fannie Mae. That is proof that Fannie’s management is incompetent. But it would cause a pig-in-python effect and mean my loss estimate for the 2007 pool is overstated.]

But – in the absence of a better model based on better data (something I think the world cannot provide us at the moment) I suspect that there is about 64 billion in excess losses coming through at Fannie Mae.

That is enough to render Fannie Mae insolvent. Indeed it is nearly enough to render Fannie Mae as “profoundly insolvent”. Not quite – but close.

I am not buying the stock here. If given a guess I would be on the short side – but I can find plenty more to short that I think is easier and more likely to be right than this.

Personal conclusion

My a-priori expectation was that Fannie was going to be better than that. If you had put a gun at my head and asked me would I prefer be long or short I would have said long.

Now I would say short.

I have no position and it is likely to stay that way. But for once I do not think the shorts are grotesquely overstating their case.

To my readers

Thank you for coming on this intellectual ride. Its caused me some grief as I have promised you a model which I could barely deliver. And it scares me to pretend I know more about the future than I do about the past and present.

But I have learnt something – and I hope you have too.

To the several people out there (including friends) who just knew in their gut what the answer would be - all I can say is your gut is more knowing than mine...

John

Losses recognised to date - and where to look for more

I was somebody who believed in 2006 that most the risks were outside the US banking system. I knew very risky loans were being made - but most were being securitised.

A lot of them wound up in the European banking system - witness Natixis and UBS.

I did however underestimate the losses that would wind up in the US banking system - and Tanta is now saying that it was a little more complicated than my 2006 view. (See this Tanta post I mildly disagree with.)

But data is what I tend to crave. Bloomberg publishes a list of total losses recognised in this crisis so far. The number just passed 500 billion - which means I think it is about half-way there...

Here is the list - but I have done something else - I have divided it into US Investment Banks (Lehman, Bear etc), US Banks dominated by investment banks (Citicorp, JPM), and conventional US banks (Fifth Third, Keycorp).




The conclusion - conventional US banks are only about a sixth of the losses. The Europeans have hurt MUCH more. What Tanta derides as conventional wisdom of 2006 was mostly correct.

What is interesting about this list is the absence of one core type of financial which is loaded with long term assets, CDOs, mortgages and other potentially toxic stuff. Where are all the life insurance companies?

I have a few shorts in that pile. There are probably plenty more - but I don't see anyone publicly berating those incomprehensible piles of mediocrity.

If you are looking at conventional banks you might find some credit losses. Indeed I am short a few conventional banks in anticipation. But they are not where I think the really good ideas are.

Thoughts anyone.



J

Post script: my classification of institutions seems fair enough in most cases - though JPM has made a fair few of its losses outside the investment bank. I also classified Barclays as a US investment bank. That seems fair enough to me...

The Bloomberg list does not include other culprits such as the GSEs, mortgage insurers and bond insurers. If anyone has a more complete list please forward it to me...




John

I was considered a scaremonger with my Swedbank post

Along with those other scaremongers at the IMF who essentially repeated the story yesterday...

See this story about the IMF warning Swedbank and SEB off their Baltic investments and the Swedish Central Bank having to down-play the risk.

I guess the IMF is scared that they will have to bail out the Baltics less the Ruskies do it for them...

J

PS - if you are interested in Russian-Baltic relations see this Wikipedia article about the Bronze Soldier in Estonia... or this BBC version...

Insolvent versus profoundly insolvent – Fannie Mae Part II

The origin of this post came about because of a blog post about Freddie Mac being “profoundly insolvent”. Infectious Greed thought it too fine a distinction between “insolvent” and “profoundly insolvent”. As this post shows I think there is such a distinction.

Fannie Mae and Freddie Mac right now have vast books of prime mortgages for which the credit is deteriorating at an increasing rate. I gave some delinquency sequences in this post and asked people to estimate where the losses peaked.

Nobody was prepared to take a guess but several people quoted back JP Morgan. If JP Morgan is right (and I will guess they probably are) delinquency is more than doubling from here and losses are more than tripling. But it is a blind guess as explained in the modelling post. It remains very bad for US domestic financials – and the more prime your business the more your credit losses will deteriorate. That does not bode well at all for the GSEs.

Fannie Mae and Freddie Mac came into this crisis with a bad history because of stuff-ups in interest rate risk management. This was explained in Part I.

Fannie Mae’s shareholder equity includes a massive tax asset – reflecting that their past sucks. [I was asked whether sucks was a technical term the other day...]

There is no question that the situation is difficult. Moreover given the thin equity they start with and the large books of Alt-A business (even if it is higher quality than average Alt A business) it is likely that the companies are insolvent.

There I said it. But that still doesn’t mean it makes sense to short them.

In my Fannie Mae Part 1 post I suggested that pre-tax, pre-provision income of an unimpaired Fannie Mae is about 10.5 billion dollars. Call it 6 billion post tax and some minimal normal provisions. If someone were to waive a wand and give you a well capitalised and well managed Fannie Mae tomorrow you might pay 13 times earnings for it – say 78 billion. [A government guarantee - implicit or otherwise - has a lot of value...]

The problem is that Fannie Mae is not well capitalised (or well managed) now. If you buy it you are almost certainly going to have to chip in equity, perhaps a lot of equity.

Under no circumstances is it profitable to chip in more than 78 billion in equity because at the end you are left with something that is worth 78 billion in total. If the shortfall at Fannie is more than 78 billion then Fannie is “profoundly insolvent”. It is so insolvent it is not worth saving. That doesn’t mean it won’t be saved. More than a few financial institutions have solved their problems by leaking out the bad news over time and doing more capital raising than their end net worth. But if the losses are more than 78 billion the first capital injection is not going to be sensible and Fannie can only survive if the capital market is prepared to throw good money after bad.

However if you “only” have to throw in 10 billion dollars then Fannie is a steal right now. The market cap is only 8.6 billion – and you would only be paying 18.6 billion for something worth 78. You would get a 4.5 bagger out of the stock. That I think is the upper limit for Fannie Mae stockholders now.

I am beginning to find a way of modelling this – subject to the radical uncertainty in the modelling post.

But that is for Part III.

John

Recollections of Alt-A

There has been a lot of chat in the blogosphere about the real nature of Alt-A loans. Tanta has a brilliant post – and his recollection is at least as valid as mine – but different. He wants to focus on the bad bits of this market (and there were many) but for today I will focus on the good.

My take on this has a very big impact on Freddie Mac – so it is market topical.

Anyway – just as there are many takes on what constitutes subprime there are a few takes on what constitutes Alt-A and here is one.

Once upon a time (as long ago as the mid 1980s) there was a well run mutual thrift in Brooklyn called Greenpoint. It had a very nice – but somewhat risqué lending business. Greenpoint is no more. It was merged into North Fork Bancorp and then into Capital One Financial – so here I am talking about ancient history.

Essentially there are a lot of people in NYC who have done pretty well for themselves despite being illegal immigrants. They have all the characteristics of good borrowers – a family, a sizeable amount of equity, a desire to maintain the lifestyle the wife and kid have got used to, and a genuine ability and intent to pay the loan. They look like the super-prime borrowers of my modelling post – with delinquency well under 1 percent.

However they were illegals. And to get a “qualifying” mortgage from Fannie or Freddie you needed to give over a lot of documentation and these people were not that happy to do that.

Enter Greenpoint. Greenpoint lent on a limited or no documentation basis but a smell test and most importantly used its own valuers who were trained by the company and paid on salary not commission. Their lending was 35% down – but the deposit wasn’t the 35 percent (real though that was) it was the smell test conducted on the borrower.

This was a very good business – but hard to scale and hard to reproduce - it made good loans by properly training staff and by using all-in-house valuers. That didn’t stop others trying using outsourced brokers. It ended in tears the first time – when Citicorp lost 500 million and Dime Bancorp lost two thirds its capital. A lot has changed since then: Citicorp has become Citigroup and Dime Bancorp has become another spoke of Washington Mutual. The quality of Greenpoint was shown when they got through this crisis essentially unscathed… They had many defaults – but the loss given default averaged three percent.

Anyway this business was fundamentally limited because Greenpoint was a mutual which always had a limited deposit base. It demutualised, purchased some branches on Manhattan for the deposit base and moved itself to a more salubrious Manhattan address (the address where the CFO told me this story which I am repeating from memory). I believe (but could be persuaded otherwise) that the term Alt-A was coined by Greenpoint to explain what they were doing. And it really was an alterative to other A grade mortgages – to distinguish it from B&C business that was the then fashionable term for non-prime mortgages.

From here Greenpoint really hit the big time. Freddie Mac agreed to buy Greenpoint mortgages on a risk sharing basis. This meant that Greenpoint had access to the GSE/quasi-government guarantee spigot and was no longer limited by its deposit base. [I always wondered about the politics of using the GSE subsidy to support illegal immigrants given the xenophobia sometimes on exhibit in Washington but…]

This allowed Greenpoint to grow – which they did sensibly at first – keeping their culture of in-house valuers and their smell test. The growth rate became more rapid - and if I had to guess - I would think the standards fell as the growth rate rose. Standards are hard to maintain at a growing institution.

They merged with a mortgage company on the West Coast doing roughly the same thing – but getting some access to wholesale funding. That company was Headlands Mortgage founded and run by Peter Paul. Mr Paul became the largest shareholder in Greenpoint.

Anyway the scene in LA probably wasn’t that much different to NYC – with a bunch of illegals made good. The merger of Headlands with Greenpoint looked like a fit despite being on opposite sides of the country. (My direct knowledge here is limited.)

Greenpoint and Headland both grew with help from their friends at Freddie Mac. This was the bi-coastal non-standard mortgage lender – and as far as I can tell it kept moderately high standards for some time - although my ability to confirm that was low and I never purchased the stock.

I followed Greenpoint for another reason. Long time readers of this blog will know I was once short a lot of Conseco. Conseco had a truly dreadful business in manufactured housing lending. It eventually cost them the company and was the first place where widespread non-fraudulent defaults of AAA securitisation paper took place. The manufactured housing market in the period until 2002 is a pretty good indicator of how a non-prime mortgage crunch works.

Anyway thinking it could do one type of non-prime mortgage with better-than-average legwork it decided it could do another. It purchased Nations Bank’s manufactured housing lending business and became instantly the number 2 manufactured housing lender in the country. They called this business Greenpoint Credit. [For those without memory Nations Bank purchased the West Coast based Bank of America and changed its name – but kept its HQ in Charlotte.] This was an unmitigated disaster with Greenpoint eventually closing the business after losses that from memory were about a billion dollars. Peter Paul was called back to run Greenpoint Credit – and when it failed he eventually resigned his position on the board. Peter Paul retreated to charity and a mortgage company on the West Coast called Paul Financial. He services mortgages and as this entry at the Mortgage Implode site shows – he has not come out entirely unscathed.

As I was searching for links on this story I found a slightly different take on it here. They mention for instance a 75% loan to valuation threshold and a business helping tax evaders buy houses. The core part of the story – being the use of in-house trained valuers however does not change between my memory and this variant.

The point I make is that this was non-standard lending but was essentially sound because the collateral was essentially sound. But it also passed capacity and character tests as well. It really was an Alternative to A lending. Alt-A as a term used by Greenpoint was not misused.

Things changed

Just as Greenpoint was copied by people with lower standards in the lead-up to 1992 it was copied by people with lower standards again. The Alt-A business had made Greenpoint rich – but – given the manic competition – it became no longer possible to do the lending at the standard which Greenpoint expected.

The last I spoke with Greenpoint management (late 2003 I think but I have no notes) they were getting pretty down on the market - very early – pointing out then the insanity of some other lenders. [Note to readers: every bank during the boom will point to declining standards elsewhere but claim that they have maintained standards. Insurance companies do the same thing – and it is not collectively possible. The correct thing for management to do when all about them are losing their heads is either put themselves up for sale or stop writing business. Both of these are however career limiting.]

They did what a sensible management team will do when the game is up. They put themselves up for sale and North Fork purchased them at a good price.

North Fork tried unsuccessfully to get a good price for Greenpoint Mortgage. Nobody purchased even though this was once the best shop on the block. I didn't follow why - but my guess is that the business just wasn't that special any more becasue everyone had access to funds. What made Greenpoint special when it was good was (a) access to Freddie Mac, and (b) the in-house valuers. By 2004 none of this mattered.

North Fork eventually sold itself to Capital One – and I have lost all contact with or knowledge of the Greenpoint mortgage business.

I mention all this for two purposes. Firstly there has been a debate about what the Alt-A market really is. I agree with Tanta that at the end (and with the ridiculous levels of risk-layering) the loans made no sense. Indeed many were probably fraudulent.

But I am not sure that this sort of lender doesn’t come back.

The second reason I mention is that there is a lot of alarmism about the Alt-A book held by Freddie Mac. Mish for example is sure that Freddie is massively under-reserved for this. I suspect Mish is right – but if the book looks like the old Greenpoint book Mish will be wrong.

There were once good things in Freddie’s Alt-A book. The delinquency of that book says it is not all bad still – but it is certainly not the quality of Greenpoint in 1995. There was an extensive discussion of Alt-A in the last (disastrous) Freddie conference call – and whilst it is clear Freddie’s Alt-A is better than industry Alt-A, it is hardly pristine. The quality of Freddie's book declines massively by year of origination - leaving open the possibility that they were once snow-white - but they drifted. [This is an industry wide trend - but it is particularly pronounced at Freddie Mac.]

If anyone has a real feel for Freddie Mac’s Alt A business now could they share it. With a hundred billion in Alt-A and one billion in provisions this is the issue in analysing Freddie Mac.

But for the moment I just wanted an anti-dote to Tanta.

J

As a further link - this post on Blown Mortgage essentially argues that Alt-A was (or became) an excuse to do lending without underwriting.

I think that is right - but it is not necessarily the case. In the days when Greenpoint had limited access to funds it lent those funds very well. As access to funding increased the quality of the lending for the whole industry deteriorated. In the end it was comically low.

J