Modelling Fannie Mae and Freddie Mac - Part IX

I am sorry for the couple of weeks delay in publishing the continuation of this series.  It was caused at least in part by my collarbone* and in part by just how difficult the next two posts have been to write. 

In this series I have shown that the biggest source of losses (actually realised) so far at Fannie and Freddie have been private label securities (notably senior tranches of subprime and alt-a securitisations).  The traditional business (insuring well secured and well documented qualifying mortgages ) has caused very few losses thus far (though substantial provisions have been taken). 

The dross in other words was in the private label securities. 

Now I stated in Part II that whilst Fannie and Freddie have made their biggest losses in private label securities they happen (perhaps by dint of better underwriting) to have the better end of the worst part of the mortgage market.  The next couple of posts aim to explore that statement and measure it against the provisions which Fannie (and particularly Freddie) have taken thus far.  I am conducting a robustness check on Part II and hence a check on the robustness of the starting balance sheet used in the model presented in Part VI. 

Fannie’s statements about better underwriting of private label securities

Fannie Mae has publicly argued that whilst they have losses on private label mortgage securities their losses are far less severe than market.  I have not done the work on individual securitisations at Fannie Mae to back that statement – but I will reproduce a graph from Fannie’s credit supplement comparing Fannie owned Alt-A private label securities with market private label securities.

 

. 

 

Note that the cumulative defaults of the pools on which Fannie Mae owns the AAA strips are running just under half the cumulative defaults of the market average Alt-A securitisation.  

They appear to have this better result without huge differences in the indicators by which they have selected the loans.  From the same page in the supplement here is a comparison of Fannie Alt-A credit characteristics with market Alt-A credit characteristics. 

 

The biggest difference is that they did fewer adjustable rate and negative amortizing loans – that is they purchased fewer loans with payment shock (when payments reset). 

I do not have any real analysis of how Fannie managed to pick Alt-A loans that were so much better than the market. I would welcome informed comment.  But the obvious place to look is at Fannies’ relationship with Indy Mac.  Fannie had a close (and costly) relationship with Indy Mac – and the above data suggests that Fannie was allowed to cherry-pick Indy Mac’s book.

That said, the close relationship between Fannie Mae and Indy Mac (which seemingly allowed cherry-picking of Indy Mac’s book) did not give Fannie good mortgages, just a better calibre of dross.

Freddie Mac’s better than average class of dross

Fannie claim to have better-than-average Alt-A private label securities.  Their mark-to-market provisions have however been lower than Freddie Mac – and I have not compared individual securitisations to Fannie’s marks as reported in their accounts.

I have made that comparison for Freddie Mac.  Freddie Mac has taken very large marks in their accounts for private label securities (and by the end of the first quarter of 2008 Freddie had reported larger losses than Fannie based primarily on these marks). 

Freddie do however have a (legitimate) claim for better-than-average selection of (bad) AAA subprime securitisations.  There will be write-backs based on this. 

Let me however introduce you to the Long Beach Mortgage 2006-11 (subprime) securitisation. 

Long Beach Mortgage was the subprime mortgage company associated with Washington Mutual.  The loans were way too risky to put on Washington Mutual’s balance sheet – and the performance of these loans is many times as bad as the performance of Washington Mutual’s own balance sheet. 

Moreover, the later securitisations were done in the subprime bubble the worse they performed.  Pools that were originated late in 2006 (such as 2006-11) behave considerably worse than pools that were originated even as late as early 2006.  There is a reason for this.  If you were a borrower who borrowed in 2005 and you could not repay your mortgage in 2006 you did not default.  Instead you simply took another mortgage (often taking cash out on refinance) and repaid the old mortgages.  Early 2004 and 2005 pools showed few losses for some time even though the underwriting standards were atrocious.  The reason was that the bad loans rolled into later securitisations.  The cynics (correctly) observed that “a rolling loan gathers no loss”.  The late 2006 pools are truly atrocious because they contain not only the bad loans originated in late 2006 but also refinances of the bad loans originated in 2004 and 2005.  The ability to refinance a bad loan just ended – with the result that the late 2006 vintage is especially atrocious.

So when we look at subprime mortgages originated by Long Beach Mortgage in late 2006 we are looking at amongst the worst credit originated during the whole bubble. 

Freddie Mac took a large exposure ($408 million I gather) to AAA strips backed by this appalling pool of mortgages.  They will lose money on that – and have taken provision.  But surprisingly they will not lose quite as much as you would at first glance think – because - despite playing in the sewer - Freddie Mac took some measures to ensure that they could at least keep their nose above the sludge. 

You will find the original offering documents for the 2006-11 series here.  Much of the rest of this post is dependent on unusual features in those offering documents.  So here goes. 

Most mortgage securitisations (or credit card securitisations or the like) had a single pool of mortgages (or credit cards) and tranched them into many strips (often 15 or more).  Credit defaults were attributed to each strip in order.  So if there were a small number of defaults junior tranches (originally rated maybe BB) would wear those defaults.  If there were more defaults mezzanine tranches (often originally rated A) would bear those defaults.  Only if there were very large defaults would the senior tranches (originally rated AAA) suffer.

Often AAA tranches had 15 percent of protection – meaning losses had to be 15 percent of original outstanding before the senior tranches lost a penny.  It was argued that it was inconceivable that say 30 percent of mortgages in a pool would default.  And it was inconceivable that the loss given default (severity) would be more than 50 percent – so (it was argued) it was doubly inconceivable that there would be enough losses to affect the AAA securitisations.

Alas we now know that to be false.  Many AAA strips are seriously impaired as defaults and severity have been substantially higher than what was considered even conceivable just a few years ago.

The long beach securitisation(s) look just like this except for one thing.  Instead of having one underlying pool of mortgages they have two underlying pools – Group 1 and Group 2.  These individually support their own AAA strips but collectively support mezzanine and junior strips.  Now this strange structure was done for a reason – the reason being that the GSEs (notably Freddie Mac) wanted to ensure that they had more protection than the average subprime pool investor.  These loans were real dross – but they wanted the better end of the dross.  This is explained in the (2006-11) prospectus.

The trust will acquire a pool of first and second lien, adjustable-rate and fixed-rate residential mortgage loans which will be divided into two loan groups, Loan Group I and Loan Group II. Loan Group I will consist of first and second lien, adjustable-rate and fixed-rate mortgage loans with principal balances that conform to Fannie Mae and Freddie Mac loan limits and Loan Group II will consist of first and second lien, adjustable-rate and fixed-rate mortgage loans with principal balances that may or may not conform to Fannie Mae and Freddie Mac loan limits.

Now don’t think the loans in Group 1 conform to Freddie’s normal loan standards.  They do not.  But they are better than the Group 2 loans.  We know this in a couple of ways – the most important is that the average original principal balance for the Group 1 loans is $185,000 versus $273,000 for the Group 2 loans.  Also the concentration in California is lower for group 1 loans (28 percent versus 54 percent). 

Now I started this with a (hyper bullish) view that whilst the Mezzanine strips of various loans might be trashed, the Group 1 loans – being pre-selected might be OK even though the Group 2 loans (the publicly traded high rated parts of the securitisation) might be very bad.  Alas that is not the case.  Indeed the surviving Group 1 loans are very bad (though not as bad as the Group 2 loans).   

Anyway here is the cumulative distributions and realized losses for the various tranches of the 2006-11 securitisation – these distributions and losses covering both groups of loans.  Note that this is a very-late-cycle securitisation and would have high expected losses as a percent of original outstanding…

This data comes from a Deutsche Bank (as trustee) monthly statement to holders of securitisation paper.  You can find the trustee report here…

The way to read this is that the mezzanine strips have been almost entirely wiped out – and the losses are coming very close to imposing on the senior strips.  For example the M4 strip had an original face-value of $24.75 million.  That is how much investors paid for that interest in the mortgage pool.  They have on that investment received $2.344 million in interest but their principal has now been wiped out.  They are gone – and there is no recovery.  However so far the losses have not been big enough to actually reduce the principal owing to the A strips.  The 1A strip (which I gather is owned by Freddie Mac and is backed by the better mortgages) was originally just over $408.0 million.  They have received all interest owning, 6.8 million of scheduled principal repayments and $143.8 million of unscheduled principal.  The are still owed $264.3 million of the 408 million invested.  On the money they have received back (in cash) they can take no losses – the money is in the bank.

The collected Group 2A strips originally invested (332.1+136.4+243.2+91.5=) 803.2 million of which ( 53.0+136.4+243.2+91.5= ) 524.1 million remains outstanding…

We also know how many loans were originally in each group and how many remain from this table…

 

And now we see the big advantage of Group 1 over Group 2.  Group 1 has 326.2 million in loans outstanding backing 264.3 million in Group 1A certificates outstanding.   Group 1 can absorb mortgage losses of $61.9 million before Freddie Mac (as the AAA strip owner) loses a penny. 

By contrast Group 2 has 534.2 million of principal balance outstanding supporting 524.1 million in AAA strips.  They can only lose a further 10.1 million before the AAA takes cash losses. 

The better-than-pool collateral backing the Group 1 certificates has helped Freddie Mac because even now – with huge losses already incurred – Freddie has taken no cash losses and still has 23 percent excess collateral.  They still have considerable protection. 

I was hoping to stop this post just here - but 

Note that Freddie still has considerable extra collateral backing their exposure to one of the junkiest pools in the whole subprime mortgage bubble.  I was hoping that excess collateral was enough – and that Freddie might – through dint of clever structures and preselecting the best loans in a pile of dross be able to get through the whole subprime thing with only mark-to-market losses that would soon reverse.  In other words I was hoping for a hyper-bullish reversal of most of the losses discussed in Part II of this series… 

Alas the remaining loans are truly atrocious and 23 percent excess collateral is not enough.  I know it is unlikely to most readers to assume you could pick a bunch of loans have more than 50 percent default and 50 percent loss given default – something that would be necessary to impair Freddie’s Group 1 AAA certificates.  But – this is a late 2006 Long Beach securitisation.  Unlikely as it might have seemed just a few years ago the losses will be much worse than that.  Here is the delinquency data for the Group 1 loans.

 

 

This delinquency is almost 20 times as high as Freddie Mac’s conventional (non-credit enhanced) mortgage book.  Different pools of mortgages can have a delinquency and default difference by a factor of 20 depending on underwriting – and unfortunately the underwriting at Long Beach mortgage was bad – even for the Group 1 loans (which were pre-selected to be better). 

There is 12 percent (and flat) early stage delinquency, 16 percent (and rising) late stage delinquency, 13 percent (and falling) foreclosure and 6 percent (and flat) bankruptcy and REO. That is 47 percent problematic loans.

I have only educated guesses as to how many of these will eventually default – but an upper end assumption is that end default should be 1.2 times current delinquency. Not all the early stage delinquents will default of course – but there will be new delinquency and some non-delinquent loans will eventually default.  Anyway a reasonable (though high-end) guess is that 56 percent of outstanding principal will eventually default.

Still 56 percent default would not impair us dramatically if loss severity were only 50 percent.  After all we still have considerable excess collateral left on this loan pool before the AAA securitisation tranches are impaired.  Unfortunately severity is running MUCH higher than 50 percent.  Here is the severity for both the Group 1 and Group 2 loans.

 

 

Note severity is running about 75 percent.  That is implausibly high and suggests very bad loan servicing.  [The severity data is the subject of the next post.]

Still this suggests that the end loss from the Group 1 pool to come is very high – 56 percent default and 75 percent severity – suggesting 42 percent of the remaining pool will be lost.

I am not going to go through this but it is substantially worse for the Group 2 loans (the ones Freddie rejected).  The delinquency for Group 2 loans is even higher.

What this means for Freddie

Remember above I showed that there were 326.2 million in Group 1 left outstanding.  We think the loss on this will be 42 percent or 137.0 million.  There is however 61.9 million in excess collateral protecting the AAA certificates.  That will all be lost and 75.1 million in losses (137.0-61.9) will be visited on Freddie Mac. 

Freddie Mac has a $264.3 million outstanding balance – they will lose (75.1/264.3=) 28.4 percent of the outstanding balance.  The structure protected them – Group 2 loans will have much bigger losses – but losing 28.4 percent of the outstanding balance is still atrocious.  Its a better class of dross.

Generalising the 2006-11 series

I have fiddled with a lot of Freddie Mac securitisations in the course of writing this series.  As a rule Freddie securitisations had structural features which meant that Freddie Mac losses were smaller than market losses but are large nonetheless.

However the 2006-11 series is a particularly bad series (subprime, late in the boom).  Most series have losses for Freddie below 25 percent of outstanding balances remaining as of June 30.  Any mark worse than that and they are going to write back the excess over time.

Here are the marks as reported in the last 10Q:

 

Note the amortised cost of the subprime exposure is 63.9 billion and the gross unrealised loss is 24 billion.  That is a 37.5 percent mark.  After careful looking through securitisations I cannot find a single securitisation where I think Freddie will lose above 30 percent – and 25 percent is more common.  On that count there is 8 billion which should run back through the accounts as they have marked-to-market and the losses will be not as bad as the market. 

The model I presented in Part VI calculated losses and income from the current position of Freddie’s balance sheet.  However here we appear to have found another 8 billion improvement on Freddie’s initial balance sheet – that is the real position of Freddie Mac is 8 billion better than I modelled in Part VI.  

Freddie Mac reckon that about 10.4 billion of the losses they have booked are “temporary impairment” and should reverse.  It is plausible – but my 8 billion is a lower number. 

Cumulatively Freddie’s accounts show about 31 billion of temporary impairment – losses that they think will reverse.  Outside subprime I have made no effort to test that number – but it seems high to me.  Moreover some of this impairment seems to come back through the currently inflated revenue line and I do not want to double count this benefit.

Summary

I noted in Part II that Fannie and Freddie had incurred their major losses to date on their Private Label Securities.  However I also asserted that Fannie and Freddie picked private label securities that were better than market – that is confirmed and alas it did not stop them from incurring very large losses.

A careful look at some bad securitisations suggest that those losses are more than full provided for (and hence Freddie in particular is slightly more solvent than this series suggests). 

 

 

John

 

*I thank the many people who have wished me well, inquired about my broken collarbone and – in some cases – asked how my treatment fitted in with my analysis of Australian socialised medicine.  The short answer is that I am going well.  My break is one of the 90 percent that current practice suggests do not require an surgical pinning.  So I have put my arm in a sling, taken huge doses of painkillers and waited for the bone to mend.  The painkillers are not pleasant.  There are lots of side-effects listed on Wikipedia including elation, hallucinations, itchiness, constipation, and excessive sweating.  I seem to have all the unpleasant side-effects and none of the pleasant ones.  I cannot fathom why people take these drugs recreationally.  The painkillers are however better than the pain – which was overwhelming. 

I have yet to reduce the painkiller doses – but I am expecting the side-effects to be unpleasant when I do so.  I will write this up later for those that are interested – especially how my experience fits in with my views on socialised medicine.

Sorry – no posting for a while…

I broke my collarbone in a bicycle crash.

Fannie and Freddie series to be continued…

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.

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.

Summary

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.

John

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.

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.

Background

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:

 

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

 

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.