Insolvent versus profoundly insolvent – Fannie Mae Part II

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

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

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

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

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

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

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

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

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

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

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

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

But that is for Part III.

John

Recollections of Alt-A

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Things changed

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

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

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

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

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

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

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

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

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

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

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

J

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

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

J

From the comments - property prices on the California beach

In the comments someone was wondering if they were mad paying $450 a square foot for a house a few blocks from their favourite California surf beach. I noted that I can't tell as I paid well over double that for a house a few hundred yards from my favourite surf beach (Bronte). [My decision was mad... but then I have a wife who is rather happy here...]

But I think we can all agree that apartments in Estonia at multiples of this price are mad. Check out this article. And we shouldn't be that surprised they have halved.

J

Estimating losses for prime mortgage books

I am struggling here with the modelling of prime and conventional mortgage losses. It matters because I am short Magic (see post). But it also matters to Fannie Mae et al.

Anyway think about a pool of mortgages which is following historical seasoning patters. For very high quality mortgages loss would be peaking (at low levels) at about year three. Subprime mortgages which are following historic seasoning patterns have losses that peak earlier.

Anyway – everything is tracking just fine – and then – for some reason the losses start ticking higher than predicted. Now you have to project what the ultimate losses will be.

By definition here you do not know. The losses are higher than expected – and they are diverging from projection. I am going to use the fashionable baseball analogy to talk about stages of the credit crisis from the perspective of bank-uncertainty.

• First base: loans are turning sour at an increasing rate. They won’t get worse for ever (nothing does) – but they will get worse for an indeterminate amount of time. You have no real basis for estimating how long they are going to get worse for. You might remember the last credit cycle and (for your business) the deterioration lasted 15 months. So you model the losses assuming a “burn out period” of fifteen months. This is highly speculative and the confidence around your estimate will be low. You might think you know what is causing the sudden deterioration of credit vis trend. But you generally don’t. Your guess will be highly speculative too – though that will not stop media and pundits from speculating. If you were going to put an honest confident interval around your estimate it would be high. You can make investments on this basis – but you are shooting in the dark.
  
• Second base: the loans are getting worse still – but they are getting worse at a lower rate. The new entrants into the 30-59 day delinquency bucket are falling and the serious delinquency buckets are rising – albeit at a much reduced rate. At this point you begin to get some confidence about the end losses. Your estimate should get more accurate because you can now see the “burn-out” rather than just having to guess it. You might get one or two write-backs but they are rare and they look desperate.
• Third base: delinquency is falling across the board. The foreclosures are humming along – the courts have caught up with the reality on the ground for foreclosures and your estimates will be pretty accurate. You can still be wrong – but it is getting obvious by now what is going on. You even have enough loan files to work out what has gone wrong. [In stage one and two nobody really knows how much is fraud and how much is ordinary credit cycle.] Write-backs of losses are regularly occurring though are less frequent than further write-downs.
• Home: the economy has caught up – some buckets are actually improving. There is still a backlog of real estate owned, but the property price has stabilised. Your estimates should be pretty good now. Write backs are more frequent than write downs.

And here is where the baseball analogy breaks down. Like baseball a lot of companies will be caught out (even insolvent) between bases. But unlike baseball you are never really home in this game. The economy could have a “double dip” recession – the so called W shaped recession. Certainty is not available.

Anyway in this schema I am fairly capable of modelling the credit losses once we get to the second base – and I am totally incompetent to model the credit losses on the first base. That is just reality. We have no real idea what is going on yet.

And at the moment we are clearly in the second base (or further) with respect to everything that was marketed as subprime 2006 and prior. If it is second lien marketed 2006 and prior we are probably in the third base because we know the loss severity too. (Loss severity = 100 percent!) And I feel pretty confident modelling it. I have even purchased a few stocks on that basis (notably Ambac which I have retained despite originally planning to sell some into the short squeeze).

But with prime mortgages we are at the first base. They are getting worse in every bucket at an increasing rate. It won’t happen forever – but if someone tells you about a model of these loans you know they are just making the key assumptions up. Maybe they are making it up with an educated guess (such as my 15 month burn out period). But they are still making it up.

And this is a problem for me because I have promised you an analysis of Fannie Mae’s credit losses – and I have also promised you that (at least on this blog) I will not make it up.

And I am not sure I can keep both promises.

I am short at least one stock because I guess the better part of their book will kill them. That stock is Magic. I think their subprime estimates are reasonable (though light) … but I sure that they do not have a handle on how the good parts of their book will behave and I am guessing the assumptions are optimistic.

However as I promised you an analysis of Fannie’s credit losses and I promised you that I wouldn’t make it up I have to come to a solution. The solution: get you to make it up!

So here are a few data series just for delinquency:

The two sequences all below 1% are Fannie and Freddie’s core book respectively. They are entirely mortgages below 80LTV and below the GSE threshold. This is the very best of the mortgage market. The books with secondary mortgage insurance are given in columns 2 and 4.

It should be observed that the good end of the credit market did not deteriorate at all until August last year. This is clear across a lot of the data I look at.

In August a lot of banks were “surprised” that the subprime crisis was spreading to their books. Well – give the management credit – if they had a true prime book and they were watching the data carefully – in other words if the management were everything you would hope they were – then they were surprised. Lesson to investors: do not call for the sacking of management who were surprised in August. [Be a little less forgiving of management who chose another month to be surprised.]

But it is pretty clear that this good stuff is getting worse at an accelerating rate. The last two months in particular have been bad.

And for the reasons explained that makes it very difficult to estimate where this deterioration is going to finish.

So – as I am not happy making it up can my readers have a go. What will be the delinquency for the insured and uninsured Fannie and Freddie books in twelve months? How about the Magic book?

Guesses anyone? Email or (preferably) in the comments.

John

Some corrections on statutory capital requirements

With one reader I have started modelling the statutory capital requirements of Magic. In the process I discovered that my understanding of the stat-capital rules was faulty - and hence some assertions made about them in this post and this post are incorrect.

If anyone is truly expert in the stat capital rules for mortgage insurers I would love an email.


John

Another blog milestone

This is the 101st post on Bronte Capital. I missed the hundredth.

On the fiftieth post I noted blog milestones. Here I will update them:

Number of large corrected mistakes was one and is now three. Correcting my own errors is one of the goals of this blog - but I would prefer not make them. [There are numerous small errors and probably some large errors I have not found...]

At post 50 cumulative visits were 3788. In the past month it has been 10848 and I have now had over 5000 unique visitors (up from about 2000). These numbers have taken off recently and I am now getting about 800 visits a day.

The subscribers have taken off - they were running at about 80 and are now about 430.

In the past the most popular posts were the first post about Barclays, and the first post about the fraudulent hedge fund in Santa Fe. They are now running at number 8 and 10 respectively.

The most popular post (surprise) is the post on Swedbank. At least that is partly because it turns up high on Google searches for the price of Eastern block hookers.

Funnily enough the throw-away on Wachovia comes in at number 2. I don't think it is amongst the most interesting things I have said.

The comments were almost non-existent at post 50 - but I was getting a small but loyal email following. The comments are now much more frequent - and for the first time getting annoying. I don't like being asked in a comment for instance how much a stock has fallen. [It is very easy to look up...] So far I have not edited or deleted any comment except when the author has emailed me and asked me to. [They emailed me because they made a mistake...]

Keep the emails coming.

J

From the comments: more on Magic

One of the reasons why I love doing this blog is that smart people disagree with me and send me emails.

And I am not wedded to any position. I change my mind.

Here from the comments is a comment that is accurate enough as per Magic now:

John...Thanks for your thoughts on Magic. We too were short the stock for some of its fall but have now gone long in significant size. Yes they underwrote a lot of crap, but the premium deficiency reserve which assumed a51% loss rate compensated for that. Now the remaining bulk RIF is only $3.5 billion per page 13 of the recent supplement. Total reserves are $4 billion or $34,000 per delinquent loan at June 30. If the cure rate is 50% (which is way below the historic number) then the reserve per real delinquent loan is more like $68,000. You are right to mention how Magic is cash flow neutral and thats important. We see Magic as generating $1.5 billion in pre provision pre tax earnings per year. Just take revenues minus operating expenses. That is alot of cash at $1.5 billion a year plus $4 billion of reserves to pay future claims. Recent book value was just below $23 per share and based on expected losses over next 6 quarters this should not get below $18 per share at year end 2009. At this point the real earnings power of Magic will shine through remember $1.5 billion pre provision pre tax earnings divided by 150 million shares = $10.00 per share. I guess you could say that makes us believe in Magic.

The Anon Guy is right in one key respect. The business is now cash flow neutral. It is however running very substantially statutory capital negative. They will run out of stat capital if the new business shows any substantial losses.

I do not believe that the deficiency reserve is adequate – but the level to which it is inadequate is not large enough to make me want to be short the stock. It exacerbates the stat capital problem but it is not lethal.

The question is whether you believe that the business they wrote in 2007 and early 2008 is sensible.

If the new business is sensible you believe in Magic. I am afraid that I do not believe but my data for that view is thin.

The trend on losses for mortgages originated in 2007 is not good. Indeed it is positively sick. The trend on Fannie Mae and Freddie Mac insured mortgages is looking not good.

In other words the core business is looking worse. However if it is only a little bit worse then my friend above is correct – and you should be be long Magic. I need the core business to deteriorate markedly to get paid on this short.

I think that happens – but any help in modelling would be much appreciated. Dear reders – send me your emails.

John

Postscript: My explanation of statutory capital requirements for Magic is slightly faulty. I have blogged about that here.

One email comment - about reserving at MTG

The GAAP reserving rules for mortgage insurers are very strange - almost prohibiting them taking reserves for anticipated defaults (except the premium deficiency reserve).

I might be harsh saying that they are under-reserved in a GAAP sense. I do not think I am harsh saying MTG is under-reserved according to common sense accounting. But I am open to being convinced otherwise.

J

Do you believe in Magic? [Fannie Mae part IA.]

This post has a couple of purposes. Firstly it is interesting in its own right – but more importantly it is key to understanding Fannie Mae’s credit profile. Consider it as Fannie Mae Part IA to go with my Fannie Mae Part I.

Mortgage Guarantee Insurance Corporation (MGIC or NYSE:MTG) is a mortgage insurance company. It was the mortgage company I hated most. I despised it. MGIC was always known as Magic – and almost whatever they said I didn’t believe. I would rather believe in witches and other black magic than almost anything the CEO of this company said.

You need a little background to know why I hated this company so much.

The changing role of mortgage insurance

There is a traditional role for mortgage insurance. The GSEs (Fannie and Freddie) were not allowed to underwrite mortgages with a loan to valuation ratio of greater than 80% without secondary mortgage insurance.

However realistically most first home buyers have never been able to put 20% down. So secondary mortgage insurance was required. This would bring the loan within Fannie Mae criteria. The traditional book of mortgage insurance companies was thus enormous piles of loans originated with 80-95 percent loan to valuation ratio – almost all loans to young couples for their first home where the total mortgage was somewhere between 100K and 200K. These loans were diversified by geography and time of origination – but not much else. They were also pretty safe.

Then a few things happened. By far the most important was that banks and the securitisation market started offering closed end seconds (CES). The idea was that you took a standard Fannie or Freddie mortgage (ie a GSE qualifying mortgage) and a second mortgage (or even two second mortgages) above that. This was the so called 80-10 product meaning an 80% GSE mortgage and a 10% second above that. There was also 80-20 product and 80-10-10 product describing different sizes of secondary mortgage.

The result was banks undercut mortgage insurers and the core product of the mortgage insurers looked obsolete. The mortgage insurers looked in a quandary – and several of the mortgage insurers had a hard time growing in the domestic market. According to the mortgage insurers association (MICA) the total mortgage insurance in force was 668 billion in December 2006 and 619 billion in December 03. That is not much growth in the most wild-ass mortgage market in the history of the USA. During that period premium rates actually fell – so revenue went nowhere to backwards.

The mortgage insurers compensated by doing other things – mostly riskier things – and that blew them apart.

• PMI went to Australia and purchased a stake in FGIC. FGIC is a bond guarantor that has been smashed.
• Radian funded a bond guarantor (Radian Guarantee – formerly Enhance Re) and blew up on it. They also invested in a fraudulent securitisation company (CBASS) I blogged about here.
• General Electric just decided it wanted to exit the space and wrapped its mortgage insurer in Genworth Financial and spun some out and sold the rest.
• Magic went subprime – and owned a stake in CBASS.

What Magic did

Magic went deep and scummy subprime. It started guaranteeing mortgages in the pools produced by the most dodgy of producers – it was particularly big into Novastar and ResCap (the GMAC mortgage business). Novastar were about as questionable as subprime mortgage providers got (and the money they owe Wachovia is a case-in-point about questionable exposures at Wachovia). ResCap by comparison were Vestal Virgins (and we know how f—ked about ResCap is). Herb Greenberg wrote more-or-less continuously about Novastar. He got a lot of flack – but he was right.

Anyway – insuring mortgages written by Novastar was a pretty quick way to the poorhouse if you asked me. Novastar also got PMI to ensure mortgages but quite quickly PMI realised what Novastar was it stopped doing business with them. Herb Greenberg also wrote about that.

Anyway Magic were the ugliest of the ugly in subprime securitisation. They insured pure crap. I couldn’t imagine how they would wind up solvent.

They then pretended it was OK by using the most absurd definition of subprime, Alt-A and prime I have ever seen. I blogged about that here. Their definition of subprime was so weak that it was possible to not be considered subprime if you had:

• A 95 percent loan to valuation in a low-end housing estate
• Where the valuation was taken by a broker-friendly appraiser at the third cash-out refinance
• Where there was no evidence that the person was able to repay principal and – to the contrary where they needed to refinance their mortgage every few years to make it current, and
• Where the customer had in the past seven years defaulted on a credit card costing the issuer money

And that was the guts of the reason why I hated Magic. It was the company with the most subprime book – but they pretended it was mostly not subprime by defining subprime in such a way that only serial credit card fraudsters seemed to meet the definition.

They also owned half of CBASS – which owned a very nasty loan servicing business (Litton). You can find out just how nasty Litton is here. I blogged about it here.

Magic were the scum of the mortgage boom.

And if you had asked me if there was any realistic proposition of magic surviving a proper crisis I would have answered no. I always said it was a $5 stock – which was just so I didn’t sound nutty saying it was a zip. [I was considered a hyper-bear in those days…]

Anyway I was wrong. Magic is sort of surviving. It is not an easy situation – but it is not completely diabolical. And sometimes I am stunned when institutions with OK management (Fifth Third) or really rich institutions (Natixis) get into trouble. But this stuns me the other way – these guys are haven’t filed the Chapter 11 they so richly deserve.

Do I have to add that they compounded these errors by repurchasing billions of dollars worth of their shares at absurd prices? No – I can thank them for it – their repurchases provided a counterparty to my short sales!

So where is Magic today?

Well – obviously they have given up doing the real dumb business. CBASS has been written off and the company has retreated to doing the traditional business of first home buyers…

I doubt I can say it any better than the Management discussion in the last annual report:

Premium Deficiency

Historically a significant portion of the mortgage insurance we provided through the bulk channel was used as a credit enhancement for mortgage loans included in home equity (or “private label”) securitizations, which are the terms the market uses to refer to securitizations sponsored by firms besides the GSEs or Ginnie Mae, such as Wall Street investment banks. We refer to the portfolios of loans we insured through the bulk channel that we knew would serve as collateral in a home equity securitization as “Wall Street bulk transactions”. During the fourth quarter of 2007, the performance of loans included in Wall Street bulk transactions deteriorated materially and this deterioration was materially worse than we experienced for loans insured through the flow channel or loans insured through the remainder of our bulk channel. Therefore, during the fourth quarter, we decided to stop writing insurance on Wall Street bulk transactions. In general, loans included in Wall Street bulk transactions had lower average FICO scores and a higher percentage of ARMs, compared to our remaining business.

In the fourth quarter of 2007, we recorded premium deficiency reserves of $1,211 million relating to Wall Street bulk transactions remaining in our insurance in force. This amount is the present value of expected future losses and expenses that exceeded the present value of expected future premium and already established loss reserves on these bulk transactions. See further discussion under “— Results of Operations —Losses— Premium Deficiency.”

C-BASS Impairment

C-BASS, a limited liability company, is an unconsolidated, less than 50%-owned joint venture investment of ours that is not controlled by us. Historically, C-BASS was principally engaged in the business of investing in the credit risk of subprime single-family residential mortgages. Beginning in February 2007 and continuing through approximately the end of March 2007, the subprime mortgage market experienced significant turmoil. After a period of relative stability that persisted during April, May and through approximately late June, market dislocations recurred and then accelerated to unprecedented levels beginning in approximately mid-July 2007. As a result of margin calls from lenders that C-BASS was unable to meet, C-BASS’s purchases of mortgages and mortgage securities and its securitization activities ceased. On July 30, 2007, we announced that we had concluded that the value of our investment in C-BASS had been materially impaired and that the amount of the impairment could be our entire investment.

In connection with the determination of our results of operations for the quarter ended September 30, 2007, we wrote down our entire equity investment in C-BASS through an impairment charge of $466 million. This impairment charge is reflected in our results of operations for 2007. For additional information about this impairment charge, see Note 8 to our consolidated financial statements. In mid-July 2007 we lent C-BASS $50 million under an unsecured credit facility. At September 30, 2007 this note was carried at face value on our consolidated balance sheet. During the fourth quarter of 2007 C-BASS incurred additional losses that caused us to reduce the carrying value of the note to zero under equity method accounting. The equity method reduction in carrying value is not necessarily indicative of a change in our view of collectability.

Well apart from not disclosing just how scummy C-BASS was all along this seems a fair disclosure. But here are the critical things for the future:

• That the excess of future claims over revenue (a premium deficiency reserve) was a bit over a billion dollars.
• That the flow business – the traditional first home business – was not showing undesirable credit characteristics as of year end.

Now, as you imagine, I never thought this company had much credibility (they continued to lie about the nature of C-BASS) and they were as close to scum as anyone I have come across in this industry. (Surprisingly the CEO has not changed.) But if the losses on the closed block of business are larger than this or the traditional business of first home buyers goes pear shaped then there is not going to be much left.

So here is the sticky question: do you believe in Magic?

The company gave us one marker that I guess you could use to test whether you believe… that marker is that they predicted paid losses this year to be just under two billion dollars.

And if you want a bull case – the margins are very much improved

Premium revenue is going up massively and they are no longer having to write business for Novastar to get that premium. Net premium written in the second quarter were 372 million compared to 321 million last year – and the total par insured has fallen from 19 billion to 14 billion.

372 million for accepting credit risk on 14 billion of mortgages is still not stunning business – it is still less than 3 percent. But it is an awful lot better than it was. However with this premium the company is still going to get into diabolical trouble if the conventional first-home owner/Fannie insured mortgage market goes pear shaped.

But current margins are not the story – the back-book and the quality of the new business is

Magic gave us a criteria by which we can judge - they told us that premium income was going to be rising and claims paid would be under 2 billion dollars this year. Surprisingly they are beating this by a very comfortable margin.

The claims paid are running at 385 million for the last quarter – about what the written premium is. The company is barely bleeding cash at all. If you had asked me whether it was possible that this – the most scuzzy of mortgage companies – could be essentially cash-flow neutral this far into a mortgage crisis this big I would have laughed and not answered. But they are essentially cash flow neutral (with a caveat that I will explain below about statutory capital). Still it is pretty hard for a company that is not bleeding cash to go insolvent. It is not impossible – but on these numbers you would have to say that you do believe in magic.

The problem with this analysis is that there is a bad reason claims paid are running below projections. It is just that the courts are jammed up, the servicers of the mortgages totally swamped and foreclosure is running much slower than anticipated.

You can see that. The delinquency on their super-scummy subprime loans is over 36 percent and rising very fast. This is serious delinquency – the company does not bother reporting 30 day delinquency (probably because its servicers do not tell it).

The company’s reserves smell very light if you adjust for this problem. They have insurance over 34 billion of bulk loans in force and they have serious delinquency on the bulk loans of is over 25 percent. They are coming in at a few billion of losses – not just the billion or so in the reserve kitty. This company looks and smells under-reserved still. And given that I probably wouldn’t buy insurance from it. Whether it is solvent or not – that is another question.

But people do buy insurance from it and in quantity – and if that insurance doesn’t blow up in their face then the company will be just fine.

Is the new business any good?

This whole thing is contingent on the new business being OK. This is a company keeping up with old losses by writing lots of new business – and to date it is working.

The new business is mostly flow business being written for Fannie Mae and Freddie Mac. It may be good business (the jury is out). But it is pretty clear why Fannie and Freddie want to support Magic. It is in the interest of Fannie and Freddie to keep this company alive. If it dies then Fannie and Freddie are on the hock for the insured business. And if Fannie and Freddie stop trusting it for insurance then the company will die.

This is a bad dynamic. Magic gets to write lots of business at today’s much improved margins at terms which might keep it alive – and it gets to do it because Fannie and Freddie refuse to face reality.

But here I think the magic is very black indeed.

Look at the delinquency rate on the flow business. It has doubled and it is running I the table above just over 6 percent. That number has me really puzzled. Indeed I needed a good lie down and think.

Why is six percent so high? Well Fannie Mae publishes the delinquency on its credit enhanced book every month – you can find it in the monthly statistics. It’s a pretty good indication of the average of the mortgage insurance industry. You can find the table in the bottom right corner of the second page of this pdf.

The Fannie Mae number is running at 3.56 percent. The Magic number is almost twice as high. Come to think of it – the Magic number is almost twice as high as the delinquencies on the 100 odd billion of Alt-A stuff at Freddie Mac which makes everyone sure that Freddie is going to fold.

This suggests to me that Magic is doing something considerably riskier than the Fannie Mae average to get the higher delinquency.

We are meant to believe that this is good business – but it doesn’t look like America. Fannie Mae’ average delinquency of under 1.5 percent looks like America. I do not get it and I have fast come to the conclusion that Magic are just unreformed and unrepentant river-boat gamblers who still operate in the risky end of what is left of the mortgage market.

It might be just the general trend that I have blogged about – that 2007 business just looks sick (see here and here). But if it is the oncoming train of 2007 business then I wouldn’t want to stand in front of it.

So in summary: I do not believe in Magic. I have covered my short – unfortunately several dollars higher than this. But something remains not quite right here.

John

Postscript: Can you go bust whilst being cash flow positive?

I asserted in my post that it was pretty difficult for Magic to go bust whilst being cash flow positive. That assertion was a gross simplification.

Magic is a holding company with considerable debt holding a regulated insurance company. When the insurance company writes premium it needs to make reserves (the so-called contingency reserve). These reserves reduce distributable capital. The losses also reserve distributable capital. The cash flow and the ability to distribute from the regulated insurance company to the holding company are not correlated.

The holding company needs to receive distribution as it has debt – and if it fails to pay that debt it will fold.

In other words it is possible for the holding company to go bust whilst the whole entity is cash flow positive. [Holders of Conseco once found that out.]

I would love it if someone has modelled the statutory accounts of this company – or could help me with that task.

John

Note: I put my MTG:NYSE short back on "last night". This is unusual for me - I originally shorted this stock above 50 and covered at 20 and 12. I put it back on below 8. For those that don't know I am in Australia - so it really was last night.

Covered bonds as a panacea – or a recipe for the FDIC to kick in more taxpayer money

I am getting jaundiced in the banks pushing covered bonds as the panacea for the housing market and the journalists who buy it. This story really got my goat because it is so one-sided.

All a covered bond is is a guaranteed securitisation.

• Currently a bank can borrow money unsecured or subordinated to buy mortgages. In which case the borrowed money carries a bank guarantee, is generally subordinate to depositors, and hits the bank’s capital ratios. In insolvency the assets are there and that helps pay depositors.
• Alternatively a bank can securitize, in which case the funding is secured, but there is no bank guarantee and hence there is no impact on the bank’s capital ratios. Ideally there is no effective guarantee at all on the assets in which case problems with those assets cannot hurt depositors.

What the investment banks want to sell is funding which is secured and carries a bank guarantee.

When a bank sells covered bonds problems with the assets hurt depositors but the assets are not available to help pay off depositors if the bank gets into trouble.

In other words it downgrades the claim of the depositors whilst not reducing the risk to deposits.

Deposits generally carry a Federal Government guarantee. Covered bonds will increase the cost of honouring those guarantees and hence increase the cost to tax payers of bank bail outs.

Paulson wants to allow this. Advice to the Senate: you will be there in 12 months. Paulson will not. Think of it that way.

J

Update

A couple of people (notably Mish) have pointed out the limitations on covered bonds will make them less useful than they might otherwise be and hence reduce the systematic risk. The Aleph Blog also made that point here.

I still think this is very dangerous. Imagine a bank in some trouble selling covered bonds. When the loans go bad they need to replace them. When the insolvency happens the bond holders wind up owning the good assets and the bad assets get left preferentially to the depositors (read the taxpayers). But the limitations which are extensive both reduce this risk and reduce the effectiveness of the bonds as a capital raising tool...