Health Care Reform and single payer – an Australian perspective

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

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

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

Australia has a hybrid private-socialised medical system.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bluntly the system works in almost every sense that matters.

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

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

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

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

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

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

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

The important way of getting lower health care costs in Australia

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

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

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

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

Reasons the US will never do this as well as Australia

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

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

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

Winners and losers

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

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

2). Universal coverage expands usage.

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

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

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

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

Modelling Fannie Mae and Freddie Mac – Part VI

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

Putting the model together

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

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

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

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

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

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

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

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

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

Implications

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

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

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

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

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

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

Bronte’s position

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

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

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

 

John

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

Modelling Fannie Mae and Freddie Mac – Part V

In Parts I to IV of this sequence I explained where the losses already realised at Fannie Mae and Freddie Mac came from – and where future losses might come from. I showed that the companies have almost reached reserve adequacy – a conclusion diametrically opposed to the consensus view that these companies are hopelessly insolvent even to the point that they threaten US government solvency. On losses the consensus appears to be simply wrong.

In this post I show how the revenue of the GSEs is up very sharply.

No competition

As far as Fannie and Freddie are concerned, the best thing about the mortgage crisis is that these institutions are now the whole market. The private sector market in US mortgages has almost entirely disappeared. They are even allowed now to do jumbo mortgages.

Lack of competition means fat margins – and just as the revenue at Bank of America rose sharply during the crisis so does the revenue at the GSEs.

Here is the quarterly sequence of net interest income for Freddie Mac. The numbers for Fannie are similar…

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

The growth in these numbers is breathtaking. Operating costs are roughly flat. You would think they are rising because foreclosure and credit management (which costs Freddie money). However I suspect that those costs are offset by lower bonus payments to staff and similar costs.

But with flat costs and revenue rising like this Fannie and Freddie are much more profitable on a pre-tax, pre-provision basis.

Not all of this growth in profit is sustainable. A bit is reversal of previously booked losses on derivative hedging instruments. (I explained this reversal in Part II and the explanation is technical – I do not feel the need to repeat the explanation here.)

Further Freddie Mac in particular has been an astoundingly good judge of when to hedge out duration risk. I wrote a post a while back about just how good Freddie’s trading has been. The seemingly superior interest rate risk management at Freddie has continued – though I would not bank on profits from that being permanent.

That said – the pre-tax, pre-provision profits at Freddie are probably going to run about $15 billion per year for a while. Much of that increase will be long-lasting as private sector competition in the mortgage market is not going to return rapidly – and so margins should remain fat. That $15 billion per year can offset an awful lot of losses.

What it means for the future of Freddie and Fannie is the subject of the next post.

Modelling Fannie Mae and Freddie Mac – Part IV

This blog is reprinted on Talking Point Memo. In that format the post is unreadable unless you click the permalink. The tables are too wide – and have prompted a reformat of my home blog.

In the last post I introduced readers to cumulative default curves. In this post I am going to create a naïve (but surprisingly robust) model of end losses using those cumulative default curves. Later posts are going to detail the limitations of this model and what (if anything) allows me to attest to the model’s accuracy...

Also I am going to use only the cumulative default curves up until December 2008. There are a couple of reasons for doing this. Firstly I am lazy and at Bronte Capital we originally did this analysis in March and I can cut and paste the internal note we wrote at our fund. More pertinently though the default curve past December gets distorted by the foreclosure moratorium which meant that some individual cumulative default curves are quite kinked. For instance the sequential default for the last four quarters on the Fannie Mae 2007 vintage is 1.1 billion, 1.5 billion, 1.0 billion and 1.5 billion. If you used the 1.0 billion default recorded in the first quarter of this year you would underestimate the end defaults by presuming the foreclosure moratorium was a continuing part of the sequence and not a distorted data-point. So whilst it appears lazy to use analysis I wrote in March not updated for new results, there is some method in that.

Here is the default curve – as published by Freddie Mac – until the end of 2008. This curve does not include the kinks caused by foreclosure moratoriums.

It has the usual “to the sky” character for the 2006 and 2007 books of business, however the kinks a the end of the curve are not present. (Compare to 2003 curve to the most recent 2003 curve which you can find in the last post – and which has a notable kink at the end of it.)

I would have loved the data points on this curve as actual numbers to run through the model. I wrote to Freddie Mac (and to Fannie Mae) and asked for that data and they refused to give it to me. So I did the best I could and printed the curves on graph paper and read the numbers off the graph paper. [If you are a policy analyst at the National Economic Council looking at this issue perhaps the company will give you actual data points!]

The last six quarters of the 2006 pool for Freddie had cumulative defaults in the following table. I have also included the cumulative defaults of the 2000 series as a comparison – and the ratio to the 2000 vintage as follows:

Last six data points	cumulative default 2006 originations (bps)	cumulative default 2000 originations (bps)	Ratio of cumulative defaults 2006/2000
Y3, q4	115	41	2.8
Y3, q3	90	35	2.6
Y3, q2	64	29	2.2
Y3, q1	42	22	1.9
Y3, q4	24	15	1.6
Y2, q3	13	8	1.6

If the ratio were constant (it is not) then we would have a really good method of projection. Instead the 2006 pool is getting worse relative to the 2000 pool quarter by quarter. My guess is that the end cumulative defaults will not be 2.8 times the 2000 pool (the current ratio) but 4.5 times (substantially worse than the current ratio). This is an educated guess looking at the charts – nothing else. I have tried testing this guess with (former) senior finance execs at Fannie. They said they would like to measure they rate at which the curves are diverging (preferably by state or market character) against rates at which house prices are falling. They want to test how much of the expansion of defaults is induced by falling house prices. They are after a sounder end-default estimate.

That said – I am stuck with the educated guess made above.

We can make a similar educated guess for other years of origination. Here it is:

	Current cumulative default (bps)	Guessed end default ratio	End cumulative default
Base year 2000	104		110
2001	74	0.8	88
2002	62	0.75	83
2003	32	0.7	77
2004	52	1.1	121
2005	81	2.5	275
2006	115	4.5	495
2007	63	6	660
2008	negligible		400

Obviously the big problem years are the 2005, 06, 07 and 08. Previous years have largely played out. That is to be expected because if you had a mortgage you couldn’t afford originated in 2004 then you either refinanced it in the boom into a later year or you have defaulted already. I have only guessed the end default in 2008 – there is simply not enough public data to make anything other than an informed guess – however gossip suggests that 2008 is a bad year but not as bad as 06 or 07 for defaults.

From here – with data about how many mortgages were originated each year – you should be able to work out how many defaults are yet to occur. This is done below. The originations for the years 2000-2003 are made up because I can’t find the data any more – but the action is not there anyway. What matters is the later year.

Year	current cumulative default (bps)	end cumulative default (bps)	Defaults still to come (bps)	Originations in year (billions)	Defaults still to come (billions)
2000	104	110	6	450	0.3
2001	74	88	14	450	0.6
2002	62	83	21	450	0.9
2003	32	77	45	450	2.0
2004	52	121	69	495	3.4
2005	81	275	194	501	9.7
2006	115	495	380	577	21.9
2007	63	660	597	460	27.5
2008		400	400	358	14.3
Total defaults still to come					80.7

This suggests that there are almost 81 billion of mortgages in the book yet to default. This is considerably more than the cumulative defaults to date – and implies a massive increase in defaults. Whitney Tilson is right – prime mortgages owned by the GSEs are going to default in a massive way in the next couple of years.

I have done a similar analysis for Fannie Mae and I predicted that just over $125 billion of defaults were embedded in the default curves at that company.

Remember though that these are defaults, not losses. Severity is the key to the losses.

Neither company publishes severity by year of origination (something I would deeply desire). However Fannie Mae publishes its severity in each period for the whole book.

The severity at Fannie Mae was as low as 9% in 2005. I do not have an accurate table of severity by year of origination – but Fannie gives recovery data as follows (severity percentage = 1 minus recovery percentage):

Real estate owned net sales compared with unpaid principal balances (which is one minus severity numbers)
2005	93%
2006	89%
2007	77%
2008 q1	74%
2008 q2	74%
2008 q3	70%
2008 q4	61%
2009 q1	57%
2009 q2	54%

The severity numbers at Freddie Mac are consistently a little lower than at Fannie Mae. I think the reason is that Fannie Mae did most of Countrywide’s business and there was more valuation fraud at Countrywide. If this is the case it strikes me that Fannie has a good case against Bank of America (who now own Countrywide) but they have not chosen to litigate.

Either way, severity is rising though with the recent stabilisation of REO sales prices (more evident at Freddie than Fannie) I think we can presume some stabilisation at the new (higher) severity levels. Anyway I ran the model assuming end average severities for various books of business. This produces an estimate of losses yet to come.

Year	Defaults to come by year (billions)	Severity by year (percentage)	End losses (billions)
2000	0.3	10%	0.0
2001	0.6	12%	0.1
2002	0.9	14%	0.1
2003	2.0	15%	0.3
2004	3.4	18%	0.6
2005	9.7	40%	3.9
2006	21.9	60%	13.2
2007	27.5	55%	15.1
2008	14.3	30%	4.3
Losses still to come			37.6

When I originally wrote this model Freddie Mac had already provided for 15.6 billion losses yet to come. That is the provisions number at the end of 2008 in the following graph.

Given that I thought that there was $37.6 billion of losses embedded in the book I thought that Freddie was under-reserved by $22 billion. This is a big number to be sure – but in the scheme of things that are said about the losses at Fannie Mae and Freddie Mac most people (certainly most taxpayers) would be happy that the hole in Freddie Mac’s book is “only” $22 billion. [The level of under-provisioning at Fannie Mae was similar… our estimate was that neither institution posed much threat to the US Treasury.]

Since I did this estimate Freddie Mac has actually realised $2.9 billion of losses and the reserves have risen to 25.2 billion. This means that Freddie has now provided for an additional 12.5 billion dollars. The remaining hole in Freddie’s accounts is now “small” – say 7.5 billion dollars.

Plausibility check

When you estimate something in such a convoluted way it is incumbent to run a plausibility check. Look again at the losses and reserve picture for Freddie Mac.

Note that Freddie is writing off roughly 900 million per until the last quarter. The spike in the last quarter to 1.9 billion was due to the expiry of the foreclosure moratorium as well as due to the generally bad housing market. I estimated that at the end of 2008 there were 37 billion in losses left to come. Since then they have realised $2.9 billion in losses including the spike in realised losses at the end of the foreclosure moratorium. I think there are now about 34 billion in losses left to come. If the next six months is twice as bad as the last six months then we will be running off at roughly $6 billion per half or $12 billion per annum. We can cope with three years that bad without threatening my estimate. Given that the early stage delinquency of the GSEs is currently falling (see this OTC report) I think this is a reasonable (if harsh) assumption.

Plausibility summary: my loss estimates pass this plausibility check. I have run half a dozen other plausibility checks (some quite convoluted and detailed). The estimates are robust to all of them.

Summary of Part IV

In this post I show how using naïve (but surprisingly robust) models using data in the cumulative default curves you can get estimates of the end losses of both Fannie and Freddie.

Using these models I show that the end losses in the traditional guarantee book of business are very close to the reserves currently embedded in Freddie Mac’s accounts. [The same applies at Fannie Mae too.]

This argues strongly against the notion that Fannie Mae and Freddie Mac will be substantial ongoing drains on the Federal budget. It also argues fairly strongly against the notion that the quasi-government GSEs cost taxpayers more than the private sector companies that they competed with. AIG – who led the FM Watch – an anti-Fannie-and-Freddie lobby group will wind up costing taxpayers considerably more than the GSEs.

Moreover the losses on the GSE’s core business (the losses modelled in this post) look like they are about the same as the original GSE capital base. If the GSEs had not (foolishly) purchased private label mortgage securities (the losses detailed in Part II) then the cost to the taxpayer would have been negligible.

This has big implications for the reform of GSEs – something supposedly under discussion at the NEC – and also of concern to many. The traditional guarantee business of the GSEs simply did not perform that badly during the worst mortgage crisis in modern finance. That should be borne in mind by the GSE critics.

As to what the end cost to the government will be – and whether there is any residual value in the remaining Fannie and Freddie securities – that is the subject of a future post in this sequence.