Friday, June 12, 2009

How brilliantly run is Freddie Mac?

Nobody writes anything positive about either Fannie Mae or Freddie Mac (the GSEs) lately. However believing that credit should go where credit is due I would remedy that.

Freddie Mac – more than almost anyone in the market got the recent interest rate shift right. That matters because (if you have not noticed) by far the biggest thing that has happened in financial markets in the last few weeks is a very rapid rise in long bond interest rates. And Freddie Mac is very exposed if they get their hedging wrong.

Given that the risks of Freddie’s exposure lie mainly with taxpayers this is something that should be celebrated.

So I am celebrating it.


The GSEs own lots of 30 year fixed rate mortgages. Nearly a trillion dollars worth each (Freddie is smaller).

Those assets become less valuable as interest rates rise. If rates for instance went up to 8% then there would be very substantial losses from holding a trillion dollars 30 year 5.5 percent fixed rate mortgages.

The GSEs can reduce this risk by either selling some of their owned mortgages or by changing their funding mix so they have fewer short term borrowings and more long term fixed rate borrowings.

Unfortunately as the GSEs remove their risk of rising rates they reduce their profits. After all it is very profitable for a GSE to borrow short (at rates close to zero) and lend at above 5% in new well collateralised fixed rate mortgages. Or it would be profitable until rates rose.

Until the end of the first quarter the GSEs were lending very large amounts funded largely short term. Freddie in particular noted (complained?) in their first quarter SEC filings that they were being pressured by regulators to grow their balance sheet to make funding available to the housing market.

And so they grew their balance sheet funded largely short term. The incremental business was highly profitable but carried a large risk of interest rate rises. (Fully hedged Freddie noted that the business was at best marginally profitable.)

When I read the Freddie quarterly SEC filings I looked at this interest rate risk – and thought – oops – here the taxpayer goes again.

But it was not to be. During April (reported in monthly data) Freddie turned on a dime and started selling mortgages, reducing their floating rate funding and increasing their fixed rate funding. They did this just before interest rates spiked.

Freddie Mac got it right.

You can see this in this monthly series. Note that the mortgage portfolio shrunk at an annualised rate of 50.9 percent – the fastest I can remember and probably the fastest ever. Moreover almost all this shrink was in long-dated fixed rate mortgages.

Freddie’s fixed rate debt increased from 582 to 603 billion – with an even larger reduction in floating rate debt.

There are plenty of people in privately run financials who wished they traded that well. All those people carted out by the sudden shift in interest rates for instance.

I know there is revulsion at paying high salaries to executives at financial institutions that have received government bail outs. But someone at Freddie Mac deserves a big bonus – a really big one.

Memo to Senator Dodd: don’t complain too much about it when the bonus gets paid.


PS. Fannie Mae’s portfolio moves were in the right direction but nowhere near the scale of Freddie Mac. I hope and expect that the bonuses will be smaller at Fannie Mae.


Anonymous said...

I'm a taxpayer. I had the brilliant foresight to give these genius's my money to play with. Therefore, I'll be expecting MY bonus. If there is any left over, the chimps can sort it out among themselves ....

Hubert said...


they most probably sold these mortgages to the Fed. I am not sure taxpayers are off the hook therefore.

Anonymous said...

John, for net duration exposure shouldn't you be looking at the Duration Gap number in table 8? My understanding is Freddie mac has operated at near zero parallel shift interest rate risk for some time now.

But What do I Know? said...

Who'd they sell all of the mortgages to, Fannie or Uncle Ben? Seriously, just because one government-backed entity made money at the expense of other government-backed entities is no cause for celebration. . . Wouldn't it make a lot more sense if Frannie wasn't borrowing money to lend it to someone else in the first place? Rent-seeking behavior, anyone?

babar ganesh said...

yeah, i was going to say -- i bet they sold the mortgages to the Fed.

that way, we get currency debasement and inflation rather than government debt.

in the current situation, sounds like a win/win.

Mrs. Watanabe said...


John Hempton said...

Alas we also know the balances of the mortgages at the FED - and it is pretty clear that it was the private sector who were suckered this time.


TheDrugsDon'tWork said...

Couldn't quite get my head around how big the sucess was. What would it equate to if long term interest rates hit that magical 6%? How much do they make by hedging now (would they still be profitable at 6%). In saying that I am just being lazy I should be able to do the calculations myself

I guess the key is who is on the other end of the trade. Who lost!

Nemo Incognito said...

Nice, so all this stuff probably ended up in good old money market funds.

Miguel Swanstein said...

This will come off as overly glib and insensitive, but brilliantly run financial services firms generally do not experience CFO suicides.

I remain wary of the health of the GSEs and hope your optimism is well-founded.

John Hempton said...

The GSEs are just a very surprising source of good trading...


and yes - it was glib and insensitive - especially as he ws not the CFO before the conservatorship.


bondinvestor said...

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.

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.

the tragedy at freddie is that they purchased non-agency AAA MBS in an attempt to meet their housing subgoals. their calculus was that the inherent subordination in the AAA's would protect them in a credit Armageddon.

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 catatstrophic losses in the Type II bonds do not necessarily imply catastrophic losses in the Type I bonds (the GSE-eligible AAA's).

if you go look at remit reports, you'll see that the DQ's underlying the agency-eligible bonds are much lower than the DQ's underlying the non-agency bonds. 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. but, given the relative performance of the loans underlying the GSE bonds, it may not matter.

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).

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.

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.

a much bigger issue for the company than the actual credit losses is the terms of the senior convertible preferred. 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.

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.

Anonymous said...

Your balance sheet read is completely wrong.. u need to understand the roll market. You should check your thoughts with someone who knows mortgages before writing such a piece.

John Hempton said...

Thanks Mr Anonymous for the advice - but I think I do know a fair bit about these entities.

Enough to express an opinion - often one contrary to common wisdom.


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