Thursday, August 7, 2008

Jamie Dimon – it is time to pay up


Yesterday I wrote about fraud in the mortgage market.

Today I will write about a single deal – the Bear Stearns 2007-1 closed end second deal insured by Ambac.

This deal is a stinker. Ambac has provisioned for an 82 percent cumulative loss rate on this deal. I have looked at the raw securitisation data and I don’t think it will be quite that bad – but it is awful.

For this to happen 85 plus percent of the loans in the deal need to default.

That doesn’t happen to normal loans. Even in the worst of crises diversified and honestly assembled pools of loans don’t default at that rate.

It only happens when there is mass fraud involved.

Bear Stearns assembled those loans fraudulently or knew the loans were fraudulent when assembled.

But it is worse. They warranted the loans would be OK.

You will find the serving agreement here. I am not a total masochist so I haven’t read all of it… however the document contains the usual clause requiring Bear Stearns to buy back and replace loans that breached the mortgage loan purchase agreement…

Jamie Dimon didn’t create this problem. Them lying scoundrels at Bear Stearns did. They misrepresented the loans – not Jamie Dimon.

But Jamie bought this problem and it is now his.

Jamie – it is time to pay up. Hope you have provisioned for it.

John

PS. Not to be too hard on Mr Dimon I have spent some time looking at securitisation created by JPM. They perform better than average at least in the areas I have looked.

Post script: I have just listed to Ambac's conference call. I said in this post that my estimate for loss on this deal is somewhat less than Ambac's estimate. In the quarter Ambac reversed some of their reserve and the reserves look much closer to my estimate. So Jamie doesn't have to pay quite as much. But he is going to have to pay...

Felix Salmon steals my thunder

Felix has the response to my "is it fraud" post. Read it.

There was plenty of fraud - unknowable amounts. And there is an awful big pig in the python.

But there is something coming after the fraud - which is plain vanilla losses.

Now here is something that I was hoping to tease out as part of the Fannie Mae story - which is what I am working to. Its what the mortgage data says:

· If the pool of mortgages is really bad it is getting better.

· The worse it is the faster it is getting better.

The deals in the ABX – which are truly awful – are improving at a rapid rate. This is indicative of a pig in the python. The loss rate for those deals is awful but the direction is good.

· If the pool of mortgages is fairly good it is getting worse.

· The better it is the faster it is getting worse.

The loss rate might not be very bad (yet?) – but the direction is horrible.

It is not like "we are all subprime now" – just that ordinary credit is getting worse – which means what was a fraud problem is morphing into an economic problem.

There are non-prime pools with 85% defaults. There is no way that is going to morph across America. So the line “we are all subprime now” is just wrong. But the there is plenty coming and it has a different profile to what has been.

John

Wednesday, August 6, 2008

What if the problem was mainly fraud?

Warning: This is a post that stereotypes people to make a point. The world is more complicated than this post – and the stereotypes are precisely that. I would love complex and real examples in the comments that question my stereotypes. I am a finance junkie – and you forget when you are looking at numbers that they embody the dreams, aspirations and failures of real people. What I seek is things beyond the stereotype… so I have different ways of reading the numbers…

There are all sorts of causes of the mortgage crisis and all sorts of results. However I want to pose a question about various types of borrowers and what their loss curves are. I am really seeking anecdotal industry evidence – hopefully from people who were once mortgage brokers or similar.

Imagine a few types of stereotypical borrower:

  • Jack and Jane are a typical first-home buyer. They have saved $10000 (which was hard) because Jack does contract work and sometimes his income is good and sometimes it is not-so-good. They have purchased their first home in suburbia. Its small – but property prices were high so they paid too much. Like almost all American young couples they aspire to a nicer second home. Contract work is getting thin at the moment and Jane might fall pregnant reducing the household income further. They are people of good character suffering mortgage stress.
  • Margaret is a divorcee. When Patrick walked out he left her with debt against the house (but some equity) and a lifestyle she couldn’t afford. However the credit card offers came in the mail and Margaret maintained her lifestyle. Eventually she had to repay the mortgage. She did so easily by refinancing the house – and even refinanced the house three times on a stated income loan. She now has a debt that she can never afford even if she adjusts her lifestyle. And she has shown no ability to adjust. Indeed she has got fatter and sorry for herself. She smokes 40 a day. [The NYT profiled such a case.]
  • Tom is a flipper. He has deliberately borrowed more than he can afford on a stated income loan. He hopes to sell the house to the next flipper. The loan would not have been granted on his real income – stable though it is – because he can’t afford it.
  • Jaylin and Ebony are a lower income black couple of good character. They were victims of predatory lending. Some unscrupulous broker sold them a loan with five points up front (hidden in the fine print) and a low initial monthly and a balloon payment so they could consolidate their car loan. The car is necessary because it is how Jaylin gets to work. I am deliberately racially stereotyping here because there is plenty of evidence that predatory loans were targeted at predominantly black neighbourhoods. This couple was just defrauded by the system. They would be willing and able to repay a decent their loan on original schedule – but the balloon payment and the five points ripped off them by an unscrupulous broker puts them over the edge. They too are distressed and angry – and their willingness to work with or trust financial institutions is also low.
  • Frank and Helen aspire to the upper middle class. He has a good job and she works part time and looks after the kids. The marriage is about as stable as the average American marriage – which means that when its good it is very good – but financial stress does strain the marriage (and marriage strain potentially strains the finances). They wanted to get the kids into a better school and hence purchased in a better neighbourhood. Keeping up with the Jones they purchased a better car on an incentive payment. It’s a big car (SUVs were fashionable) and the gas price and the lack of overtime is stretching Frank’s budget. But they want to keep the kids at the good school. They have fallen behind on the mortgage payments – but they make payments occasionally –and they can afford to make lesser payments without catastrophically adjusting their lifestyle.

Everyone who has followed this industry has seen borrowers that fit these stereotypes. However people are varied and complex and if you limit yourself to such stereotypes you are going to miss out on the richness of the world. The press articles tend to follow one stereotype or another - and hence also miss the richness of the world. As I am in Australia (reading bank account statements) and many of my readers are in the "real world" I seek comment.

That said – my guess is that these stereotypes have very different default profiles even in a diabolical real estate market.

On the stereotypes I have given you two of the buyers are essentially irredeemable – and three of the buyers could work the loan out with a little bit of forbearance, some modification of loan terms and a little bit of flexibility. The lenders will still take losses – but they won’t be catastrophic losses.

Think what happens if you modify the loans to Margaret, the debt ridden divorcee, or Tom the Flipper. You tell them you can keep the house if only you make 70 percent of the payment you originally promised.

  • Margaret got herself into this position because there was no way that she could afford her lifestyle. She borrowed by fraudulently overstating her income. She has no hope of repaying even on modified terms. The best hope for the lender is to close her up. If she gets her act together she won’t be homeless for long. But life is about to get much worse for her.
  • Tom the flipper can’t repay either (but he might be able to make 80% of scheduled payment). The problem is that Tom the flipper has no incentive to pay. He is seriously upside down [negative equity] on the loan and he only wanted to flip the house for what is now a very unlikely profit. Tom’s best strategy is to walk - and he was gaming the system in the first place - so he will walk... Again he got there through fraudulently overstating his income. The bank has the property and Tom’s lifestyle won’t change much.

Compare this to the other borrowers:

  • The typical first home owners Jack and Jane are going to be very reluctant to default. They have a proven ability to save (witnessed by the deposit that they saved). They want to join the middle class. They still see homeownership as the way there. If the lender modifies their loan they will get paid most of it. Indeed you might receive all of it. It is unlikely that a well modified loan will cost more than 10% of outstandings. Jack and Jane still have a high chance of default in a recession - and there can be a tragedy underlying this - but they will fight not to default.
  • The couple who were victims of a predatory loan are a bit more difficult. Unscrupulous brokers working for Novastar and similar companies have ripped 10 thousand plus dollars out of these people. That ten grand has gone – it has been spent. Our borrowers have paid interest at say 4 percent but accrued it at 10 percent. They now owe much more than the house is worth. They could reasonably pay the loan on the original terms – and an omniscient owner of the mortgage might restructure their loan that way. But the mortgage is now owned by a defaulted subprime pool and it is not obvious who has the power or incentive to restructure the loan. The restructure will also change the value of different classes of the mortgage securitisation. So they are going to default in my view. The loan might be able to be restructured in a perfect world – but this is not a perfect world. They will default quite rapidly when hit with increased coupon on their loan. There is an out for the lender –just the lender doesn’t know how to take it.
  • My last couple will pay (almost?) all the loan and all their loan under modified terms because they want to keep their kids in that school. But they need the loan to be modified because they are at the edge of being able to pay. Still they will cut entertainment, holidays and shrink the car to stay in the house because they want their kids in that school. If there is a recession and the husband's hours get cut - well you should probably modify the loan as that is a better outcome for the bank than foreclosure.

Note that some of these are fast defaults and some are slow defaults. If you stop rolling loans the flipper and the divorcee default almost immediately. The victims of the predatory loan default after the low-coupon period expires. The other two loans might not default at all – but whatever happens they will default slowly. They are going to try and hang on.

My point: the fraudulent loans here (stated income, predatory) have fast defaults. The non-fraudulent loans here (typical first home buyer, middle American aspirant family) have slow defaults if they default. One group can’t or won’t hold on. The other group tries desperately to hold on and might succeed.

Or in summary: fraudulent lending leads to incredibly massive and very rapid defaults with little chance of cure. There is no point offering forbearance – it won’t work.

However once the pig (a pile of fraudulent loans) has worked through the python (the mortgage market) then the bulge (defaults) will decline just as rapidly as it rose.

Non-fraudulent but stressed loans take time and if we are seeing increasing defaults now we can expect to see them for another five years. Loan forbearance programs make sense – but they can’t stop the rise in defaults over the next three to five years.

This is where having readers around the world is really useful. To what extent is it fraud – and to what extent is it old-fashioned bad lending. Does this differ by State or even area within States?

If you look at the loss curves for companies (shooting straight up) and extend them then pretty well every institution is insolvent.

Arguing from the stereotypes – if it is fraud is the dominant problem in the mortgage industry then extending these loss curves is wrong – and the losses will drop sharply once the “pig is through the python”. Many institutions that look difficult will turn out OK.

By contrast: if the problems spread to non fraudulent loans then extending the loss curve for many years is the correct analysis – and all sorts of institutions (including the GSEs) are insolvent.

You see why I am looking for comments. This is the Sixty Four billion dollar question – or – more accurately – the trillion dollar question.

I have my views – but data on fraud is particularly hard to obtain because when you survey people they don’t volunteer that they have been fraudulent. So – as the usual data-driven guy that I am I find this one difficult to nut out.

Thanks for the help

John

Tuesday, August 5, 2008

Just some comments on the email I am getting

I have received a few comments on the Fannie article – which I was going to include in the parts II and III – but as the comments in the email just keep coming I will put something up now:

  • The first comment is that I can’t possibly believe that they are solvent given that they are 130 times levered to a really bad housing market.
    • I make no such suggestion at all. I simply have not got an answer until I do the credit analysis. However I can say that the inventory and delinquency numbers that they have right now do not indicate insolvency – for them to be insolvent a lot more bad loans have to come through the system than have already come through the system.
  • The second – and more sophisticated comment is that all insurers raise rates when times are bad – but it doesn’t save many of them – so why should I spend so much time exploring this effect with Fannie?
    • Well – the pricing effect does save some insurers. It only saves them if they can continue to write business – so I don’t ever talk about the pricing effect with MBI or ABK who are effectively in runoff. But I still want to work the numbers.
  • That the repo inventory at Fannie is 20 percent in Michigan – even though only 3 percent of their exposure is there.
    • That is a real issue which I hadn’t picked up on but should have. When you are as levered as Fannie if a single large state economically falls into the ocean then you can die. I have blogged several times about how bad the housing market is in Michigan (see here and here). It is entirely possible that Fannie loses a very much larger proportion of its inventory. However the point remains that losing 100% on the current inventory is not a problem – for Fannie to be insolvent an awful lot more loans need to pass through the inventory.

As it currently stands very few of Fannie’s losses are in California. Simple logic suggest losses are going higher – much higher. I haven’t worked out any estimate of how much higher – but please keep those emails coming.

Also – my first substantive dig didn’t point out just how exposed to catastrophe risk Fannie is. Fannie has a lot of exposure in LA. The house price in LA currently sucks – and if a major earthquake were to flatten the Inland Empire not only would it be a human tragedy – but I doubt anyone would want to rebuild a large number of the houses. What is a bad situation there for Fannie could turn suddenly diabolical. Warren Buffett once said that he thought Fannie Mae had more super-catastrophe risk than Berkshire. That is a big call by a man who should know…

On the price of hookers in Bulgaria – someone suggested that I could get my readership way up if I were to publish a price index for hookers by jurisdiction.

Well I tried…

No seriously – in the comments was the astounding observation that people in the Baltic States travel internationally to buy food. They suggested pretty well every jurisdiction – but Poland appears to be the consistent answer. This story suggests that food is more expensive in Tallinn than New York or even Finland. I can assure you that not much is cheap in Finland and that this is just another measure of an overpriced currency. Driving to Poland for big shops makes some sense…

But if you wish to confirm that Poland is cheaper than the Baltic States you can do so other ways. The immigrant population of London (who send remittances) will do that for you. Or get on the web and look at the prices of escorts. It will probably do that for you to.

On the last method of research – there is a company in India called “Escorts”. I once worked at a global fund where one staff member legitimately trolled the web for stories about Escorts in India

Monday, August 4, 2008

How people find my blog

I use Google Analytics to track things like how people find my blog.

Sometimes it surprises me - but yesterday I had not one - but two visitors from the Google search "how much does a hooker cost in Bulgaria".

Oddly Google ranks me as the authority to answer that question. I suspect they will fix that rank soon - as I am a happily married bloke living in Australia who has never been to Bulgaria or owned or shorted a Bulgarian stock. For that reason I have preserved this page:



Well dear readers, I don't much care how you got here. Welcome anyway.



John

Picking apart Fannie Mae – PART ONE

Warning: This post in this form contains NO conclusions. I do not express a position on whether the stock is a long or short. I hope to get there by Part III - at the moment I am just conducting an intellectual exercise for me and my readers.

I have had hostile email suggesting that I couldn't possibly suggesting that the stock is a long. I am not. And I will not without a close examination. And I won't suggest its a short without a similar examination. That is the way I want this blog to work...

There has been an awful lot said about Fannie Mae and Freddie Mac of late. Almost none of it contained numbers. If they contained numbers they were just off-the-bat (ie analysis free) estimates of what a bailout might cost.

I can understand why. I had a go at picking apart Fannie Mae. The deleted post can be found here. It was one of the more embarrassing mistakes I have made. I just left a zero off a calculation and produced nonsense. Moreover I ran the calculation past one of the best known hedge fund managers in the world – and he never noticed the missing zero either. (One of my precious readers pointed it out – keep those emails coming.) My hedge fund manager friend doesn’t publish a blog – so you don’t see his mistakes… I assure you he makes them…

Picking apart the numbers is fraught with difficulty. Very few of us are used to thinking in trillions – and the rules of thumb we develop (is that a big number or a little number) become useless. I left off a zero and because the number was so big it didn’t seem too small…

This is the first part of an attempt at picking apart Fannie Mae. I started writing this without any preconception as to whether you want to be long or short. I might wind up at a conclusion – but forgive me if I sound vague or indecisive. That truly reflects my state of mind. You will find out the conclusions the way that I am finding them out – by actually running through the numbers.

Disclosure: I once knew an awful lot about Fannie Mae. I fully understood their accounting fraud before it was disclosed. Indeed I could accurately count the size of the fraud (and I was correct within a couple of billion dollars). I never understood why OFHEO with 200 staff could not (or would not) see it. I was short a lot of Fannie Mae and – whilst I made some coin – I was genuinely shocked at how little interest the market took in Fannie’s misdeeds. Having not made much money when I was right I went on to work out other ways to be right not make money – and I let my detailed knowledge of Fannie Mae lapse.

The range of outcomes to this project is enormous. It could be that

  • Fannie is shockingly insolvent – and hence to be avoided like plague or
  • The problems are overstated and Fannie is solvent – moreover because the competition has been removed it is likely to be far more profitable in the future than it ever has been in the past – and you should buy it because its best days are in front of it.

I am trying to start this project with no opinion.

I apologise to bond market experts who might read this post. The first bit assumes you don’t know what “negative convexity” means or how to measure it. I am going to try do this without much bond market jargon.

How Fannie Mae makes money

Fannie Mae is in two businesses.

  • The guarantee business: Fannie Mae bundles up mortgages, guarantees them and sells them as “pass-through certificates”. In this business it takes only credit and fraud risk and it earns only guarantee fees.
  • The portfolio business: Fannie Mae also buys mortgages for its own balance sheet and funds them using wholesale borrowings. It borrows money fairly cheaply because of a quasi-government guarantee. This allows it to make a reasonable spread by owning mortgages. However in this business it takes funding risk and interest rate risk. Because it owns the mortgages and will suffer if they default it also takes credit risk.

Now for those that are not familiar with the inner-workings of Fannie Mae I will surprise you. By far the most important business is the portfolio business. The spreads are much larger in that business and the business usually generates the bulk of Fannie’s revenue. It is also where the accounting frauds were found.

Mismanagement of the portfolio business has – over the years – cost Fannie tens of billions of dollars. The reason why Fannie has so little capital and credibility going into this cycle is that it stuffed this business up comprehensively.

The guarantee business is what is causing Fannie a lot of trouble now has – for most of Fannie’s history been trouble free. [Standard mortgages had a very low default rate until this cycle.]

This table gives from p.46 of the last annual report details Fannie’s total exposures. [Warning – head for large numbers needed as the numbers are in millions.]

year end data

2007

2006

2005

2004

2003

Mortgage portfolio

727,903

728,932

737,889

917,209

908,868

Fannie Mae MBS held by third parties

2,118,909

1,777,550

1,598,918

1,408,047

1,300,520

Other guarantees

41,588

19,747

19,152

14,825

13,168

Mortgage credit book of business

2,888,400

2,526,229

2,355,959

2,340,081

2,222,556

Since Fannie got into trouble on interest rate risk it has shrunk the portfolio business from 917 billion to 727 billion. It however sharply increased the guarantee book of business.

The credit guarantee fees are low – but are rising. The credit costs have been very low until recently (a single basis point). They were easily manageable last year. Here are the average fees and credit costs for the past five full years.


2007

2006

2005

2004

2003

Average effective guarantee fee (in points)

23.7

22.2

22.3

21.8

21.9

Credit loss ratio (in points)

5.3

2.2

1.1

1.0

1.0

These tables are not strictly comparable because one table is year end and the other is year average. However ignoring this complication we can see that the guarantee business would have been very profitable in all years (but almost certainly loss making in 2008 and 2009).

The thing that is startling is how low the guarantee fees are. In 2003 Fannie Mae had 2.2 trillion of credit exposure. If you take 21.9 bps on this the total guarantee revenue would have been well under 5 billion. Indeed the annual report gives them as 3.4 billion – but it does not classify the profit from some credit exposure in on-balance sheet mortgages as guarantee income.

5 billion sounds a lot – but the post tax profit of Fannie Mae in 2003 on the restated accounts available to shareholders is almost 8 billion. The money wasn’t made on the guarantee business – it was made on the portfolio business.

Given that the profits historically came from the portfolio business we need to understand the portfolio business to see how it really makes its money.

The portfolio business

Fannie Mae buys mortgages. It finances them by issuing debt – “reference notes” and the like with a quasi-guarantee from the US Treasury – and makes a spread. This is old-fashioned banking business – but Fannie doesn’t take deposits.

There are a few problems with this. The first problem is that Fannie actually has to borrow the money and be able to ensure that it can always borrow the money. If Fannie can’t borrow it will fail. That almost happened recently – but since the Feds have made it clear that they stand behind Fannie it is unlikely to happen again. It’s a real risk though. I have made it clear many times (here, here) that the biggest risk faced by many banks is the ability to finance themselves. Government guarantees help a lot though.

The second problem is more continual. Fannie Mae has no idea what the duration of the mortgages it owns is. This was a very big problem indeed in the period 1999 to 2004 when there were massive waves of mortgage refinance in America. The mortgages might last ten years – or they might refinance next week. This could (and did) cause massive problems for Fannie.

The logic is as follows.

Imagine rates were to rise a lot – so that people were very reluctant to refinance and the lifespan of the mortgages were to extend to ten years. Then Fannie would want to have its financing fixed for ten years. Otherwise there could be a real problem. If the financing wasn’t fixed then the funding cost would rise and Fannie’s spread would go negative. If you are levered as many times as Fannie a large negative spread will make you insolvent quite rapidly. So when rates rose Fannie wanted to have its financing fixed.

However if rates were to fall everyone would run off to their broker (this was 2004 remember) and refinance at a lower rate. If Fannie had fixed its finance it would now have ten year finance for ten years it would now own low-yielding mortgages with old high-cost finance. The spread would be negative again. Of course it would be alright if Fannie were floating-rate financed because as rates fell the finance cost would also fall.

So Fannie had to perform the neat trick of having fixed cost financing whenever rates rose and floating rate financing whenever rates fell.

This is of course impossible.

But you can come pretty close using derivatives. What you would do is have finance of a mix of durations and buy “interest rate swaptions”. The “swaption” would give you an option to enter an interest rate swap (ie to fix or unfix your finance) at various times. That way Fannie could fix its finance when rates were rising or have floating finance when rates were falling. The swaptions were of course expensive.

Fannie could (and did) also hedge its interest rate risk by other methods including:

· issuing callable debt (which is clean but expensive and was favoured by Freddie Mac), and

· delta hedging (which is a trick of high finance that involves selling things when they fall in price and buying them back when they rise in price and hence losing money which is expensive).

You will notice that all these hedging methods are expensive and Fannie thus continuously lost money on derivatives. Derivative fair value losses at Fannie have over the past five years totalled 28 billion. (You need a lot of spread to make that up and make a profit – and Fannie made a profit in those five years.)

The frauds at Fannie were in the derivative accounting. The accounting is also a mess because Fannie accounts for the derivatives on a mark-to-market basis but accounts the spread on a yield to maturity basis. This mismatch makes the accounts incomprehensible to almost everyone (including myself most the time).

I won’t tell you how I worked out the fraud and quantified it – but Peter Eavis (a fine journalist if there ever was one) worked out a fair bit of it and put it here.

One thing that made the portfolio business hard was that the mortgage market was huge relative to the treasury market. To hedge risk Fannie needed to trade in the treasury market or buy swaptions from people who traded in the treasury market. The size of this trading moved treasury prices – and the resulting changes in interest rates were always to the detriment of Fannie. The size of Fannie and Freddie relative to the market for US Treasuries made it difficult for Fannie to hedge.

The decline of the portfolio business

Before the mortgage crisis hit the Fannie Mae portfolio business went into very sharp decline. The profitability of Fannie Mae shows this – dropping from 8 billion in 2003 to 3.5 billion in 2006 even though the book of guaranteed business continued to rise. Even a tick-up in guarantee fees could not offset the profit decline.

There are a few reasons for this. I haven’t quantified these in order of importance but I suspect (with limited evidence) that the last one is probably the single biggest factor:

  • Yield curves got less steep – and so Fannie lost the option of financing at close to 1 percent and lending at 5 percent.
  • Fannie shrank the “owned balance sheet” under regulatory pressure – from over 900 billion to just over 700 billion.
  • Fannie reduced the amount of risk it carried – by buying more swaptions and issuing more callable debt. Lowering risk lowered profit. You can see the lowered risk because the “effective duration gap” that Fannie is running has fallen sharply over the years. [The duration gap is published in Fannie’s monthly data. A duration gap that jumps around a lot indicates that a lot of interest rate risk is being taken. At ones stage the published duration gap got over a year – which is an awful lot when you are levered as much as Fannie Mae. On a trillion dollars of mortgages a one percentage adverse movement in rates across the curve will cost you 10 billion dollars if you have a one year duration gap. The duration gap is now normally less than a month.]
  • Fannie let the book run off resulting in a natural decline of spread.

The natural decline in spread as you run the book off is second nature to anyone who deals with mortgages but is not obvious to outsiders. It’s as follows:

In any pool of mortgages there are a few that will last a long time and a few that will refinance next year. If you “match” finance them you will have some finance that matures in a long time and some that matures next year.

The short dated finance is cheaper because the “yield curve” generally slopes upward. So the mortgages that don’t last very long have more spread in them than the mortgages that last a long time. As the book runs off you are left only with the low-spread business.

Anyway – however you count it Fannie Mae’s spread based portfolio business ran off – and its credit guarantee business expanded – just in time for the credit losses to hit them hard. Expanding credit risk into a crunch can’t be much fun!

A possible re-emergence of the portfolio business

Fannie’s reduced reliance on portfolio business is a pity – because if you haven’t noticed the yield curve is quite steep at the moment, interest rates are not massively volatile (reducing the cost of the hedging), and Fannie’s funding advantages are intact courtesy of Paulson et al.

Moreover Fannie can hedge far more easily now in the Treasury market because the Treasury market has grown so massively courtesy of 43s incessant government deficits.

If Fannie were to grow the spread business now it would do so at high spreads. If it were to chose to (or be allowed to) run considerable interest rate risk it could easily get the spread to 120bps (an old level). All treasuries under ten years yield under 4.2 percent. Some shorter dates yield under 2 percent. Fannie should be able to finance at 50-70bps more than Treasuries especially with explicit Treasury guarantees.

The yield on an on-the-run wholesale mortgage with a Fannie guarantee is about 6 percent. [See this graph.] Depending on where on the yield curve Fannie finances it will pick up something like one and a bit to three and a bit percentage points of spread. The “swaptions” will reduce this – but it should be possible to earn 140bps spread on 700 billion of owned mortgages if Fannie whilst hedging a fair bit – but by no means all of their interest rate risk. [They could go bust on that risk – so this is a non-trivial caveat.] 140bps annually on 700 billion is over 10 billion per annum.

Rising revenue on guarantee business

It is also entirely possible for Fannie to raise the guarantee charge on new mortgages to well over 30 bps – and the fee on the whole book will continue to rise. My guess is that the guarantee fee will rapidly go to 30bps - but 25 is a gimme. [The quasi government guarantee is worth a lot in this time of uncertainty.]

The Treasury guarantee and lack of competition will allow the guaranteed amount to go to 3 trillion. 25bps on 3 trillion is 7.5 billion. Guarantee fees were over 5 billion last year and rising rapidly – so this is not a stretch.

This looks very like 17.5 billion in revenue.

Sanity check on revenue numbers

I am back working out what the revenue numbers might be not what they are. They are considerably lower primarily because Fannie has spent the last three years shedding interest rate risk. [One of those funny things – Fannie made the same mistake as me – being petrified about interest rate risk when the right thing was to be petrified about credit risk.]

The guarantee figure estimate (7.5 billion per annum) is probably low. The last quarter the number was 1.7 billion up from just over 1 billion. At this rate of change we are very likely to get to guarantee fee income of 10 billion at some stage. Certainly the credit crisis is driving guarantee fee revenue skyward. The average effective guarantee fee is now 29.5 bps. This has risen about 50 percent since the early parts of this century.

Interest rate income is much harder to estimate. The accounting for this always sucked because you never knew what the right level of derivative expense to include was.

Net interest income was over 1600 million for the quarter – but there was over 4000 million in “fair value losses”. On that front it was not a good quarter. But the “fair value losses” are a mark-to-market concept and the interest income is a yield to maturity concept. Still if the revenue pre-derivative cost is 1.6 billion per quarter I ain’t getting to 17.5 billion per year. I am not even getting to 10 billion. Sure the 1600 is up from 1000 million quarterly as the situation gets better in the portfolio business. But unless Fannie again takes some serious interest rate risk the portfolio business is going to be stuck earning less than 6-8 billion annually.

My sanity check fails. But the possibility exists that Fannie will surreptitiously up the interest rate risk again. In which case we can get big revenue numbers. The problem is that it wasn’t very nice last time they tried it!

So let us take the low-ball numbers. The low ball numbers are revenue for guarantee business if 7.5 billion per annum, and revenue for the portfolio business of 6 billion per annum – total revenue of 13.5 billion.

Expenses other than credit losses and mark-to-market expenses

Fannie is just a big financial machine with very few staff which makes money on guarantee fees and interest rate spreads and loses it on credit and derivative hedging costs. Staff costs are close to irrelevant. Administrative expenses are about 500 million per quarter and falling. [There are half a billion of other non-interest expenses in the first quarter – but they are minorities and debt extinguishment costs and shouldn’t really concern this analysis.]

So pre-credit cost profits of Fannie are about 2 billion per annum. They will rise as credit remediation costs rise – but let’s be nasty and call it 3 billion per annum.

Pre-credit costs profits of Fannie

On this calculation the pre-tax, pre-credit cost profits of Fannie Mae will be about 10.5 billion per annum. It will be wildly volatile because the accounts of Fannie are wildly volatile due to mismatches between the portfolio and the portfolio hedges. But that – I believe – is about the underlying run-rate.

Credit costs – the problem of the moment

To date Fannie’s big problems – the ones that caused them to raise capital last time and restate – were interest rate hedging losses. Now it has credit problems. And nobody really has any good idea of how bad the situation is.

But let’s dismiss some alarmist stuff. There were plenty of alarmist pieces about how much housing stock Fannie Mae owns right now. This article suggests that Fannie and Freddie combined owned 6.9 billion of forclosed real estate – less than 5 billion of which is at Fannie Mae. They might lose 30% on it (though even that is not clear).

Well let me say at the outset that those losses are irrelevant. If they had a loss after foreclosure of 50 percent they wipe out about three months of earnings. That would be no threat.

The real estate inventory that Fannie is currently sitting on – being many thousands of houses and many thousands of families in personal tragedy – is irrelevant financially to Fannie Mae. So steer clear of the alarmist stuff. If Fannie only winds up with say 15 billion of foreclosed real estate it will skate through this crisis just fine.

What we need to really hurt is 50 billion of losses over three years – maybe 20 times Fannie’s current inventory or real-estate-owned (REO) needs to pass through Fannie’s ownership. That would wipe out three years’ profit, plus 20 billion in capital and cause all sorts of social and regulatory stress. [We could also blow up on interest rate risk!]

In summary: if the losses are less than 20 billion you will do OK buying Fannie on any of the panics. If the losses are say 50 billion the financial and regulatory stress will be such that Fannie is problematic.

If the losses are 70 billion – say seven year pre-tax earnings – then Fannie sucks as investment and the best you can hope for is a number of dilutionary capital raises. That is if the Feds don’t just confiscate it from you.

But to want to be short Fannie on the fundamentals you need the real estate owned to wind up more than ten times the current (horrific) level of inventory.

Does that happen? My instinct is no – but I would prefer examine the numbers.

I would love help modelling this – but I think it waits for Part Two.

John Hempton

Sunday, August 3, 2008

Fixed currency and bankrupt states - Estonia next

One of the things about fixing your currency is that you can’t print whatever you are fixed to.

Indeed that is the advantage of fixing your currency. Fixing your currency forces and monetary credibility because it effectively removes the printing press as an option. But if you don't respect that force you pay a nasty price.

Its iconic – but when a country with weak economic credentials fixes its currency it tends to have an economic boom. The fixed currency in Argentina last time round was very popular because of this.

But – if you don’t maintain discipline on fiscal and monetary policy you hit the wall very hard indeed. The usual response to a downturn (just loosen monetary policy) becomes unavailable. As a result you get smashed.

So it is with this in mind that I report two stories from the Baltic Business News. The first one might have been triggered by my blog (which has been somewhat controversial in the Baltic States):

Hansabank Estonia CEO: devaluation would bankrupt Estonian economy

The Estonian CEO of Hansabank, Priit Perens, told aripaev.ee that in case loans have been handed out in EEK, devaluation would make the situation easier, but as loans are based on EUR, devaluation would bankrupt Estonian economy.

“Traditionally, ca 70-80 pct of loans in Estonia are based on EUR, so devaluating would make the situation worse. Devaluation would mean that in order to repay the loan, you’d need more EEK than before. It would, in essence, bankrupt Estonian economy,” Perens said and added: “No one is interested in devaluation right now – everyone would loose from it. In a situation, where loans were based on EEK, devaluation would help to ease the loan burden.”

To the question, whether Swedbank has been adding addition pressure to Hansabank lately, Perens responded with a curt: “No.”

Followed quite literally by the second article:

State doesn’t have money to pay pensions in 2009

Gertrud Levit

In 2009, pensions are growing by EEK 2.7 billion when compared to this year, taking up 21 pct of state budget. The state, however, can’t cover the growing pensions from social tax.

Pension index is recalculated every year and it depends on the yearly growth of consumer price index and accruing of social tax. That is why in the coming year a fifth of the planned state budget (EEK 20.4 bln) is taken up by pensions. The state can’t cover all of it from social tax, the Ministry of Finance shed light to the state budget, writes aripaev.ee.

Both inflation and the growth of social tax have been higher than expected, which is why pensions will be growing more than usual in the coming year as well.

The Ministry of Finance isn’t worried about only pensions. The capacity of foreign investments, co-investments and setting aside money for health insurance fund are jumping higher as well, but most of the money accrued to the state budget has a certain goal. Meaning that the funds can’t be used to cover holes, even if the state treasury has the needed amount of money.


You can’t make this stuff up but the last article is a little strong. Estonian politicians still hope to balance the budget.

The State is bankrupt and it can’t print money because the currency is fixed.

It can’t borrow because people expect it to devalue. They are about to have pretty severe austerity measures right into a recession...

The interest rate in Kroon is much higher than the interest rate in Euro – so the domestic population borrow in Euro.

What can I say other than so long and thanks for all the fish.

This is too familiar

Saturday, August 2, 2008

New Fannie - just like the old Fannie

I am a data driven kind of guy.

And every now and again I like to play with numbers in spreadsheets and the like.

I figure I am not alone in capital markets being a little like that.

And I like it when companies make it easier for me. Its part of being “transparent”.

I would like to comment on Fannie Mae’s new commitment to transparency.

I sent Investor Relations and email:

Do you release sets of financial data in spreadsheets - for instance the data in your quarterlies and annual reports and the data in your monthly reports?

I am finding it VERY frustrating not being able to get spreadsheets to do my calculations.

John Hempton

And the new open Fannie Mae replied:

Mr. Hempton,

We do not provide financial data in spreadsheet format on our website. However, using the Word version of any of our quarterly filings, you might be able to "cut and paste" any of the tables into Excel. The Word version of the documents is available from our web site at:

http://phx.corporate-ir.net/phoenix.zhtml?c=108360&p=irol-sec&secCat02.1_rs=26&secCat02.1_rc=25

Hope this helps.

Fannie Mae

Investor Relations

New Fannie – just like the old Fannie.

From the comments section - Latvian bank deposits

Hi! I am from Latvia. What do you think, what happens to people deposits in EUR at worst scenario? We have legislation, that government guarantees about 10 000 EUR for deposits. Where will they get this money?

Thanks

I have no idea how Latvia plays out and no useful knowledge of Latvian politics. But in Argentina they just converted everything to pesos at the old exchange rate:

http://www.commondreams.org/headlines02/0104-03.htm


If Argentina is a model your guarantee will be in Lats in the end...


However it has worked differently in some crisis situations.

--

One person (someone who thinks I am wrong) in the comments section points to a Hansa Bank executive pointing out that Estonia goes bankrupt if the Kroon devalues:

http://www.balticbusinessnews.com/Print.aspx?ArticleID=ba4449d7-bd41-4fe2-b7ba-bbf713312f8c

No. Estonia is bankrupt right now. The Kroon devaluing is just Estonia hitting the rock of reality.

And the Estonian CEO of Hansa is right. There is no pressure from Swedbank. Its head-in-the-sand stuff there.

Friday, August 1, 2008

Wachovia will walk-over-you

I get about two emails a day seeking my views on Wachovia. I am going to disappoint people who want a really detailed examination.

But I will give my quick views before I get to the real point of this post:

Wachovia is a bank with a credibility problem and a funding problem. Whereas I think a smash-em-up insolvency is unlikely at WaMu because WaMu has enough core deposits the same is not true at Wachovia. Core deposits at Wachovia are 390 billion and falling slightly. Total deposits (including hot-money deposits) are 435 and rising. [The deposit trends at Wachovia are worse than at WaMu - though as you will see later the research for this post is giving me some concern at WaMu.]

Loans are 476 billion and rising. The reasons for the rising loan balance are not entirely apparent (and leaves me suspicious). But whatever the reason, rising loans represent rising need for funding.

There is a lot of wholesale funding (especially loans pledged with the FHLB and the Federal Reserve). Bluntly is a shortage of ready funding at Wachovia and Wachovia needs more.

And as the loan problems at Wachovia look a lot worse than average it’s unlikely the capital markets will be generous. They might lend to Wachovia – but they will demand collateral, high rates or both.

So what does a bank in that position do?

It pays up for deposits. Big time.

I got this email – which, so far, I have not confirmed:

Wachovia, in two markets I do business in as a financial planner, has begun offering special rate CD way higher than any other market participants. 5% for three years! Non jumbo btw regular deposits and they claim they can offer double insurance protection by using their bank of Delaware Sub.!

What I can confirm however is that Wachovia is trying very hard to get deposits. Here is the featured deposit advert if you go look on their website. It varies a little by zip code – but they appear to have this high-rate offer in most states.

They are offering an APY of 4.25% on a 12 month CD, minimum deposit 5 grand.

And here are the high rate CDs as listed on BankRate.com.

Wachovia – through its many branches – is offering a rate as high as all but a few diabolical brokered bank CDs. It is paying top dollar.

Now I got to observe something here. The only banks that have a higher rate than Wachovia are Amtrust Direct, Heritage Bank and Corus. Even GMAC bank has a lower rate.

But when I did this survey yesterday WaMu wasn't on the list. Now it is. Comment to come... but this weakens my case for WaMu preferred...

I guess 4.25 percent for deposits is not top dollar when your credit default swap is where it is at the moment. But if you have to pay that much over the odds for money then it rather eats into your margin.

If you are not convinced that Wachovia really is paying over the odds – then have a look at Wells Fargo CD rates (choosing California as jurisdiction). The advantage of not having a funding problem is large at the moment. [I have no opinion as to whether Wells is a good stock or not – but it does have a funding advantage!]


Moral

Banks that are highly dependent on hot-money CDs for their funding have a problem. If Wachovia is competing with you for those large branch CDs then Wachovia will walk-over-you.

Or, tempted by high rates, maybe your customers will just walk-over-to-them. Either way – if your funding is “non core” your margins will be under pressure.

A request

I used to look at bankrate.com to find out which banks were “keen” for funds. But the Wachovia rate is not advertised on bankrate.com. [I used to look for short candidates amongst the banks that were prepared to pay up – and I wasn’t alone – so maybe banks are not reporting to bankrate.com any more.]

If my precious readers scattered all over the world now notice banks that are advertising very high rates locally could they email me. I would really appreciate it. I am very interested in Norway - but I have only a few readers there. Please!

John

General disclaimer

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