Monday, August 31, 2009

Sorry – no posting for a while…

I broke my collarbone in a bicycle crash.

Fannie and Freddie series to be continued…

Wednesday, August 26, 2009

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.

Tuesday, August 25, 2009

Modelling Fannie Mae and Freddie Mac – Part VIII

In Part VII I did an “idiot check” on my credit loss numbers. They appear pretty robust. This post does an idiot check on the pre-tax, pre-provision profit estimate. Here I am less confident.

The massive rise in GSE pre-tax, pre-provision profits is one driving factor behind my assertion that the GSEs can recapitalise. In the Freddie Mac 10Q from the first quarter was this (often quoted) and profoundly bearish line.

Our annual dividend obligation, based on that liquidation preference, will be in excess of our reported annual net income in nine of the ten prior fiscal years. If continued to be paid in cash, this substantial dividend obligation, combined with potentially substantial commitment fees payable to Treasury starting in 2010 (the amounts of which have not yet been determined), will have an adverse impact on our future financial position and net worth, and will contribute to increasingly negative cash flows in future periods.

This line – or variants on this line are repeated multiple times in the recent 10Q.

This is a blunt statement that Freddie could never repay the government because it owed the government $5.2 billion per annum and that was more than the earnings in almost every prior year.

There is a little that is disingenuous about this statement – possibly deliberately. The statement compares the obligations to the Treasury to the post-tax, post provision income for the past decade. In most years the pre-tax, pre-provision income of Freddie was in excess of $5.2 billion (which would have allowed some repayment). But far more to the point – the current pre-tax, pre-provision income is in excess of $15 billion. After write-backs they dealt with over 8 billion of the 50 odd billion outstanding in one quarter in Q2 – but they are not permitted to make the actual repayment (more on that in a later post).

Here is a cut-down version of the profit and loss account from the last quarter:


Revenues – net of mark-to-market swings – are up from 2.3 billion to 4.4 billion. Administrative expenses are down slightly. Pre tax, pre provision profits are probably running above $4 billion per quarter.

But that of course nails down the problem. The situation is so rosy for the preferred (and survivable for even the common stock) precisely because the pre-tax, pre-provision income is so high. If the high pre-tax, pre-provision earnings go away so does the taxpayers’ chance of getting repaid on their Fannie and Freddie bailout money – and – for that matter – so do the preferred securities that we at Bronte Capital have so carefully (and cheaply) accumulated.

First lets see what the margin is for

Fannie and Freddie make their margin two ways -

1. By charging guarantee fees for mortgages that it guarantees, and

2. By holding mortgages and earning a spread.

The guarantee fee margins were a fifth of a percent of outstanding balances or less for as long as I remember. I always thought that those margins were insanely low – and indeed the very low margins for insuring credit risk is (in my opinion) the main reason why Fannie and Freddie were in long-term-trouble. Banking systems without enough profitability cannot survive bad times. I have blogged about that extensively – see here for a (controversial) example. Those guarantee fees are going up but by no means enough. It would not be unreasonable to charge 0.4 percent however under Conservatorship and even with an absence of competition fees have not risen to that level. In the absence of competition Fannie and Freddie should be able to raise guarantee fees sharply. They should too – otherwise the fees are not reflective of risk. However the fees have not risen by quite that much – and the only explanation I have is political interference. (Again you will need to wait for another post.)

However with a guarantee book of less than 3 trillion dollars guarantee fees – whilst important – are not the way in which this company recapitalises. Guarantee income was about 700 million last quarter. Not small change to anyone but Fannie and Freddie – but not enough to produce the profit stream necessary to cover forthcoming defaults and to repay the government. My guess is that the guarantee fees rise over time but only if the regulator allows them to rise.

The driver of high-pre-tax, pre-provision profitability is high interest rate spreads. They are high because of lack of competition. Interest margins are rising pretty well everywhere in banking – but not as intensely as at the GSEs. There is roughly 900 billion on the book. Making 1.2 percent on that – which does not seem unreasonable but is much higher than the traditional Fannie or Freddie margin will get you to solvency – however solvency for the GSEs emerges after say 7-8 years under this normalised income scenario. The current spreads are way higher than normal – unsustainably high. Those unsustainably high spreads might lead to very rapid recapitalisation.

Now obviously some of the excess spread is due to the steep yield curve. That will go away – but if the company were solely playing the yield curve the spread would be much higher than it currently is. Last I looked the spread between floating rate Fannie obligations and wholesale guaranteed mortgages was several hundred basis points.

The income is also inflated at the moment because charges that were taken as the companies went into conservatorship is being reversed through the net interest income line. I wish I knew how to quantify this. (I described this issue in Part II.)

Unfortunately at some point the trend in income will be down. When income goes down so does the ability to repay. Close observation of the margin between GSE treasuries, GSE debt and wholesale guaranteed mortgages indicates that the margin peaked a couple of weeks ago. Two-weeks of data is not convincing – but my guess is that pre-tax, pre-provision operating income will be about flat (maybe slightly down) in the third quarter and will trend down (perhaps slowly) from there.

Risk of being forced to shrink

The first and obvious risk is that the GSEs will simply – by government fiat – not be allowed to earn the spread. When the GSEs were put into conservatorship they were obliged to shrink their balance sheet fairly rapidly after the first two years. If Fannie or Freddie shrink their balance sheet they will shrink their spread income. If this is done rapidly enough they will never repay government. The requirement to shrink the balance sheet has been reduced dramatically – and is unlikely to be enforced in the absence of a robust private sector mortgage market. Obviously the reality (that these companies are by far the dominant mortgage providers at the moment) has sunk in. Shrinking them now would blow up a good part of the recovery. But I suspect that some politicians will want them to shrink. (Others will have different feelings – again the subject of a later post.)

When the Republicans (for example Spencer Bachus) want to force the issue on Fannie and Freddie right now, that is what they are suggesting. If you allow them to shrink they inevitably die – and they cost government when they do so. Indeed it appears that the Republican agenda was always to destroy these companies. I will discuss the politics in a later post. The politics is interesting – as in the Chinese curse. We live in interesting times…

The second risk to the GSE income is that somehow competition comes back into the mortgage market. I suspect that is a few years away. We only need to last a few years for the securities to be visibly money-good. Nonetheless I can’t imagine the spreads remaining this wide indefinitely.

The third risk is that Fannie or Freddie massively stuff up their interest rate hedging and fail to adequately hedge the mortgage refinance risk or the short term interest rate risk on their book. Fannie had a (relatively) minor hedging problem I think in 2002 in which they were short duration and interest rates moved against them by about 10 bps in one day. My count at the time was that they lost $8 billion. They could do that again. I have no way of estimating the chance of that – but I am relatively comfortable with the interest rate risk in the book at the moment. [Losing $8 billion in a day is relatively minor only when compared to the losses that Fannie has had on the credit cycle. Interest rate risk is part of these businesses.]

The commitment fee

At the end of this year the government has the right to charge Fannie and Freddie a commitment fee (mentioned in the quote above). The size of this fee has not been determined. This fee does not change the end loss to taxpayers but it may change the value of Fannie and Freddie’s preferred and common stock. An excessive fee could lead to a fifth amendment complaint by preference shareholders. However it is a real risk to this thesis.


I am a preferred shareholder and – as a shareholder in anything – nearly always worried about risk. But if I had to tell you what keeps me awake at night it is essentially political decisions crimping Fannie and Freddie’s ability to earn revenue. In particular they may not – by government fiat – be allowed to charge adequate guarantee fees. They may – by government fiat – have to shrink their book very radically thereby reducing spread income. They may – also by government fiat – be kept perpetually insolvent by way of the forthcoming commitment fee.


Post script

A note… I was a little more sloppy about the costs at Fannie and Freddie in Part VI than I should have been. Some accurate criticisms have been received as to how I broke up cost items. However I note that costs are seldom more than 12-15 percent of revenue at the GSEs. The GSEs are large wholesale institutions – buying bulk mortgages and doing finance in bulk. Costs do not matter much. What matters is revenue (this post) and credit losses (last post). When it comes to the 10Qs I have always read the cost section relatively fast as it is relatively unimportant.

The real risks to my thesis are on the revenue line and in the credit cost estimates.

Friday, August 21, 2009

Modelling Fannie Mae and Freddie Mac – Part VII

In Part VI of this series I came to the (non-consensus) conclusion that both Fannie and Freddie were long-term solvent and that the cost to the government of their conservatorship would be zero.  I also suggested that the common stock had value and that the (non-cumulative) preferred shares (currently trading at 4c to 6c on the dollar) would one day receive par. 

There are model sensitivities and economic sensitivities to this conclusion.  In this post I want to (begin to) explore how robust those conclusions starting with the model in Part IV.  I am conducting an “idiot check”.  In the next two posts I will do idiot checks on Parts V and Part II

I apologise in advance as these three posts will look a little disjointed compared to Parts I to VI.  In this post I am using all sorts of anecdotal or practical data to test my hypotheses… this is a practical - not a theoretical exercise – and it is as a result messy.


In Part IV I built a model which predicted future credit losses for Freddie (and told you I had done so for Fannie).  We know that there are huge credit losses coming at Fannie and Freddie as delinquency is rising, house prices are awful and default is becoming more commonplace.  My model allows for huge losses.  The main question is whether the losses allowed for are quite huge enough.  The bears (and there are many) seem to assert losses considerably larger than I am projecting.

Well lets start with one of my favourite charts of the traditional mortgage guarantee business.  Again I do this only for Freddie Mac – leaving the reader to do it for Fannie if they want.


In this graph we have $1.907 billion in charge offs during the last quarter and 1.104 billion in the quarter before.  The charge-offs were effected by the foreclosure moratorium which would have meant charge offs were understated in Q1 and overstated in Q2.  Lets call it an average of $1.5 billion per quarter.

At the end of the 2nd quarter there were 25.2 billion in reserves.  I calculated in Part IV that an additional $12.5 billion would need to be provided for over the out-years.  We have thus built 35.7 billion of loss reserves (current reserves and reserves to be taken) into our model.  The key sensitivity question is: is this enough?

Well – if the loss rate does not get any worse then $35.7 billion at $1.5 billion per quarter would last 23.8 quarters or almost 6 years.   I can be fairly confident that if realised loss rates do not rise then model reserves are adequate – as the alternative requires A substantial numbers of people who obtained their mortgage in 2006 to remain current until 2014 and then default.  That is possible if the economy is really sour in 2014 – but it is not an obvious or expected outcome. 

More realistically I am modelling realised losses rising for some time before falling.  Foreclosure stats are rising in aggregate – albeit rising at a slower rate.  If realised losses were to double we could last three years and still be reserve adequate.  That is roughly what the model would imply.  If realised losses triple and remain at that rate then (unfortunately) my 35.7 billion in losses still to come will wind up being an underestimate.  So in a sense – what is required is some comfort that the realised loss rates – particularly in the nasty 2006 and 2007 vintages are unlikely to much more than double from here.

Test 1 – what is happening at on the ground in California

California is the worst state for losses for both Fannie Mae and Freddie Mac.  Some states (particularly Arizona and Nevada) have higher losses as a percentage of loans outstanding.  Some states (particularly Michigan) have higher severity – with many houses recovering less than $2000 on foreclosure.  But California is a massive state with high house prices and high losses.  Arizona and Nevada are simply not large enough to make my estimates wrong.  California is.

Fortunately California has very good data on defaults, notices of trustee sales and recoveries at trustee auction courtesy of Foreclosure Radar.  Paul Kedrosky has pointed out that we have reached the “new normal” in California – a stabilisation of foreclosure processes at high levels. 


The point is that the worst state has stabilised.  This tends to indicate that the defaults are not even going to double from here – let alone triple.  On this piece of evidence my default loss estimates are over-stated and Fannie and Freddie will return to full solvency more rapidly than I previously anticipated.  Moreover – adding to the robustness – the proportion of realised losses happening in the “bubble states” (California, Nevada, Arizona, Florida) has been rising by quarter – not falling – so it is reasonable to assume that as-go-the-bubble-states-goes-the-whole-book.

Test 2 – early stage delinquencies

Early stage delinquency (particularly 30-60 day buckets) is the best leading indicator in delinquency data.  90 plus delinquent loans will continue to rise well after the economy or credit cycle has turned because bad loans accumulate – especially when selling foreclosed property is hard.  By contrast loans going through the 30-60 day bucket give you an idea of the flow rate into problem loans.  When the 30-60 day delinquency improves you know the credit problems are ameliorating (even though the 90 day buckets are getting worse).  One of those hopeful leading indicators is that in many categories of loan I look at the 30-60 day buckets are improving – and usually improving more than seasonal factors indicate.  [That bucket is seasonally difficult in February when the Christmas bills come due and easier in summer because there is more overtime or temporary work about…  Incidentally 30-60 day buckets are getting better in some credit card books as well.] 

Fannie and Freddie (unfortunately) do not give early stage delinquency data (I believe because the loan servicers report the data inconsistently).  However the office of thrift supervision has recently conducted a survey.  You will find this chart – and much more data like it on the OTS site.



Again this indicates that is unlikely the charge-off will even double.  It is unlikely to more-than-double – and again it seems my loss estimate is too high.

Estimated defaults versus amount in mortgage pool

The model presented in Part IV estimated losses for each year of business.  Here is the table again:



Defaults to come by year (billions)

Severity by year (percentage)

End losses










































Losses still to come



Now we estimate that (as of year end 2008) there were 13.2 billion of losses (and 21.9 billion in defaults) left to come in the 2006 year of business.

The Freddie Mac credit supplement gives us other data about the credit in that year of business. 




There is in the 2006 vintage only 236 billion of unpaid principal balance left – and that number is falling quite fast.  (The rest has refinanced, defaulted already or been repaid.)  We have built into our model a 9.28% default rate from here.  Given that the seriously delinquent loans are only 6.34 percent that seems a little harsh – all seriously delinquent loans need to default and then there needs to be another serious round of new delinquencies.  Given that most delinquencies cure (even in times like this) because people with a default notification often try hard to pay rather than have their house foreclosed on – the required foreclosures being about 1.5 times the current delinquency does appear to be a high estimate. 

I guess – and people will say this – that people could walk-away with loans going from current to default very rapidly.  34 percent of the loans have a current loan to value ratio above 100 percent and almost all of those loans are current.  My only counter – and I know this is a weakness – is that whilst it may be in their interest to walk-away from their mortgage they are not doing so.  It could be that they are unaware that their home loan is underwater (and there is some evidence that Americans know house prices have fallen but delude themselves about their own house).  It could be that they just have good credit , the house is not far underwater and they want to pay.  It could be that they have scattered daddy’s ashes in the backyard and walking away is unthinkable.  More likely – with a 90% LTV loan on a 200 thousand dollar house you might not walk away even though the mortgage is underwater because the mortgage payments are lower than the alternative rent payments.  Whatever – they are not currently defaulting.  That is all I can say on this data.  If people have data that suggests that this will change soon I am interested.  I see no data in aggregate proving that point although there has been some data about the extent to which people are deluded as to the value of their own home and that their level of delusion is economic-conditions correlated.

The shift in housing problems

The housing market crash began with low end housing.  In most markets jumbo mortgages retained fairly good credit until recently – though there is considerable evidence that upmarket housing is experiencing trouble now.  There is also considerable evidence – much of it anecdotal – that lower-end housing prices have stabilised.  [Certainly in most markets it is considerably cheaper to buy low-end housing and make mortgage payments than it is to rent.]  This is generally supportive of my thesis as the critical 2006 and 2007 books at Fannie and Freddie contain no mortgages above $330 thousand.

An observation about second derivatives

As indicated in Part VI we at Bronte purchased Fannie and Freddie preferred stock fairly aggressively at below 2 cents in the dollar.  It was March when we first started doing that – and the world looked like a sour place.  The idea that Fannie and Freddie might actually be solvent seemed unthinkable – but we were busy thinking it

At the time everything was getting worse at an increasing rate.  The expression is “free-fall” – where you simply accelerate towards some immovable hard object.

The modelling did not feel very robust and the reason it did not feel robust was that all the leading indicators were getting worse.  In the curves in Part IV the 2006 and the 2007 curves were accelerating away from 2000 curve.  They did not look bounded at any multiple of the 2000 curve that I could get comfortable with.  I knew defaults would continue to get worse for a while because there was a big build-up in the delinquency buckets and delinquency is a precursor to default.

What would make me confident (and believe me I was not confident) was a deceleration in the rate things were getting worse.  I was interested in the “second derivative”.  For a while (up to about April) the second derivatives all looked good.  Briefly the second derivative of total delinquency looked bad (as reported in Fannie’s monthly data) and that really rattled me.  I posted that here.  That data-point was – it turns out – an exception to the general trend.  Only recently there have been a few bad data points (for instance the recently reported rise in early-stage delinquencies at Capital One Financial suggesting a “W shaped” recovery).

With anything that looks like a W shaped recovery this model could be wrong.  For instance we could have another big leg down in either property prices or the economy.  The data does not generally support that second leg down but that might change.  The Capital One numbers have given me pause. 

But more generally we are making predictions which are ultimately just guesses.  I hope I have convinced you that they are educated and rational guesses.  But guesses nonetheless.

The main objection I have received so far – is about loans with risk layered terms that Fannie and Freddie have in their traditional book

There have been a few objections (mostly in email) that suggest that I assume away much of the dross in the conventional Fannie and Freddie books.  Here is one email from “bob”, a mortgage market professional.

Well reasoned, but... there is a presumption in the marketplace that Fannie & Freddie's book of traditional business is solid stuff.  One has to really question that.  What about the 100 LTV loans made to borrowers with 570 credit scores and 67 DTI's?  What of the 90 & 95 LTV Interest Only loans made to flippers?  What of the 90 LTV Stated Income loans (many made to flippers)?  What about the LTV's being based on stretched and hyped appraisals?  What about the mortgage company "art departments" which cranked out custom W-2's and paystubs to document loan files with?  What about all of the high LTV loans made to people with 50% DTI's and no money in their checking accounts?  And how do you square it all with a huge and growing percentage of mortgaged homeowners who are underwater- far too many of whom are (or soon will be) unemployed or making substantially less than what they were?  Then to top it off, one can only shake their head when it comes to REO disposition practices.  Bottom line, I think any model must attack the assumption that the GSE's book of traditional business is solid stuff.  Unfortunately, Fannie & Freddie were aggressive hedge funds operated to generate executive bonuses, and under the supervision of a defanged regulator.  I'm afraid that when the tide finally goes out, it will not be a pretty sight.  [Emphasis added…]

I will deal with this in a modelling context – but then also in specifics.  My model – which just assumes that defaults in the 2006 and 2007 vintages follow a curve with a similar shape to the 2000 vintage – makes no assumptions whatsoever about the content of the book.  It just looks at the 2006 book, notes that it is currently defaulting at 2.8 times the rate of the 2000 book, that the difference between the 2006 book and the 2000 book is expanding – and hence the end default may be 4.5 times the 2000 book.  Essentially though I am assuming because things are getting worse they are going to continue to get worse

One thing however is generally true about the mortgage market – which is the very bad loans default fast in a crisis – and then the defaults from that pool ease up, whereas good loans default slowly and defaults do not ease up for a long time.  That is consistent with simple models of human behaviour.  If you have a 100LTV loan which you purchased on a property you intended to flip in the Inland Empire then you have probably walked already.  Why?  Because the incentive to keep making the payments on a cash-flow negative property is very low.  You will probably pocket three months rent whilst the bank actually gets around to foreclosing on you – but your motivation to pay is low.

If – by contrast – you are a regular mom-and-pop buyer who purchased a home to live in and put down even 10% (which you saved by dint of hard work) then your incentive to walk-away is low.  You have emotional investment in the property even if your financial investment is wiped out.  The incentive to pay (because you do not want to be forced to move) is high.  Moreover there is a real tendency to self-delusion as to the value of the property and self delusion lowers default rates.

If a book consists of flippers and 100LTV loans then the defaults will be front loaded.  My model assumes that the defaults are rear-loaded.  The more of the drossy loans described by Bob the more the defaults will be front-loaded and the more my loss estimate is thus an overestimate.  If Bob were right I would be more comfortable with my estimates – not less comfortable.

Unfortunately – despite the protestations of Bob (and others) there are actually relatively few truly risk layered loans in the traditional books of Fannie and Freddie.  For that I need to explain risk layering.  Consider the following three loans:

Loan A is made to a customer with terrible credit (a FICO of 580 reflecting past defaults).  However the customer has clearly reformed and they now hold a stable job which you have verified.  They have saved up $25 thousand and they are buying a very low-end property (say $130 thousand) in a non-bubble state.  This is a low FICO loan or a loan to a subprime borrower – but with otherwise good characteristics.

Loan B is made to someone with pristine credit and a stable income.  You have verified the income is more than adequate to serve the loan.  The family has emotion invested in the house as they have purchased near the school in which they enrolled their children.  However the down-payment is only 3 percent because the equity that they had saved had been blown because the family had recently had medical problems.  This is a high loan to valuation loan - but with otherwise good characteristics.

Loan C is made to a customer with terrible credit (580 FICO reflecting past defaults).  The customer has a stable income which you have verified – but they are purchasing a 250 thousand home with only a 3 percent down-payment.  There is little evidence in their past behaviour that that they are capable of saving money for a rainy day.  This is a risk layered loan in that it has two major risk factors – a subprime borrower and a high loan to valuation ratio.

With these three Loan A and B are probably both good under almost all circumstances.  The first borrower shows little record of past willingness to pay a loan – but in this case they have a real incentive to pay and the ability to pay.  They probably will pay.  The second borrower shows a very good willingness to pay and the ability to pay – but their incentive to pay (being the remaining equity in their home) is low.  Nonetheless they have emotional commitment to the community and foreclosure is a difficult option.  Loan C is terrible.  You have the bad borrower and they lack incentive to pay.

The collapse in underwriting standards that occurred in America was due to risk layering.  Two risk factors is many times more risky than one risk factor.  Fannie publishes a table of how many of their loans have various risk factors. 



From this table you can estimate how many of the loans have multiple risk factors.  If you add up the special risk factors you get $1,112 million.  However the actual dollar value of loans with a risk factor is 878 million and those loans are 72 percent of losses thus far. 

The numbers also suggest that at most $233 million have more than one risk factor.  That is less than 9 percent of Fannie’s book has risk layering – but my guess is that those small number of loans will be about 40 percent of losses.

The point is that the proportion of losses from risk factor loans is now declining (consistent with the argument above).  It is loans without risk factors (the heart of the traditional Fannie and Freddie business) which is going to show increasing losses.   

Fannie gives some data on loans with two risk factors – separately breaking out loans with a FICO below 620 (which means the borrowers are truly subprime) and with a LTV above 90% at origination.  There are only 25.4 billion of these – 0.9 percent of the book.  However these loans represent 5.7 percent of all losses – they are more than six times as loss intensive.  Note that the proportion of losses coming from this pool is falling – probably because the loans have a tendency to default fast – you get loss burnout.  The subprime loan pool – 0.3 percent of books but 1.1 percent of losses has had even faster loss burnout.

Anyway – contra to Bob’s email my estimate is more likely to be an underestimate precisely because there is not that much risk layering in Fannie’s book.  If the losses burn out fast then they are not likely to rise far from current loss levels.  If the losses burn out slow (which is what would happen with lower-risk mortgages) then loan losses could rise for a long time as families slowly burn through their financial resources trying to keep current in their mortgage.

Sensitivity as to the income line

I am fairly confident about my estimate of credit losses at Fannie and Freddie.   Those are manageable – and the end loss to taxpayers is very unlikely to be large.  I am much less confident that the income line (which has expanded greatly) can remain so generous.  And for the losses to taxpayers to be zero I need the companies to be able to earn their way out of their current predicament.  I need the current large operating income to continue – or at least not to drop suddenly.

The sustainability of the operating income is the subject of the next post.

Thursday, August 20, 2009

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. 

Wednesday, August 19, 2009

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.


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.



*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.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.