Bronte Capital

The missing details: Bronte Beach edition

2009-11-15T16:46:00.001+11:00

Saturday afternoon and I had volunteer lifesaving duty. My (broken) collarbone is knitted enough to be able to go in for a swim in modest surf – but if there were a difficult rescue I would pass the duty onto someone else. Really I am a pair of eyes – the job is to watch and assess – not to make a hero of myself.

I was sitting chatting with Rod, a fellow lifesaver at the North end of the beach watching quite a large crowd and getting modestly annoyed when the (fibreglass) board riders were sailing too close (or into) the flagged bathing area. (Swimmer’s heads tend to come off badly when hit with a fibreglass surf board.)

At the very south end of the beach is a rip (a current that goes out to sea) and some lifesavers were standing around chatting around the rip. This is the same rip where the Muslim men were rescued last November.

There was someone swimming in the rip – with quite good – even stylish strokes. But he was getting nowhere. Rod and I were debating whether he was even likely to get into trouble. The stroke was – as I said – strong – but given the current what he was doing was futile. We watched for about a minute when I decided to walk down the other end of the beach and see what the other lifesavers wanted to do about it. I was not worried.

As I walked the guy stopped swimming – just gave up – and started to drift out to sea at about 1.5 metres (5 feet) per second. I got to the lifesavers about the time I thought it was actually going to be necessary to go in and get the guy – but the professional lifeguard on the beach had run down, got a rescue board and was already on his way to effect the rescue. These are the same lifeguards from the TV series.

The victim was still treading water, the surf was not rough – and I suspect if he knew what he was doing (that is knew to swim across the current) he could have rescued himself. But I was still a little peeved at myself for missing the easiest of board rescues (and the kudos/self congratulations that would go along with it).

Ex post we realised there were a few missing details:

First – the lifesavers at the South end of the beach simply did not notice the guy caught in the rip. Maybe they noticed his fine swimming stroke and assumed he was not a “customer”. Maybe they were looking at pretty women in bikinis. Maybe they were just preoccupied. Whatever – they did not see.

Second – the customer was from Bavaria. He was a tourist. He had once swum competitively (hence the stylish swimming stroke) but he had never swum in the surf. He simply did not understand his predicament and he had no idea how to get out of it.

Third – the customer was wearing cut-off cotton jeans – not a nylon swimming costume. That makes it just so much harder – and an amazing proportion of our rescues are of people who go in fully or partially clothed. [The fully clothed are often Muslims.]

Fourth – the customer had had a couple of beers.

If I had known these four details I would not have walked to the other end of the beach – I would have run as fast as I could. Those details – none of which were readily apparent – changes the interpretation of the guy in a rip from “interesting and slightly comic” to “life-and-death”.

The existence of a problem was obvious to me – and I (incorrectly) presumed that it was similarly obvious to my fellow lifesavers. I just assumed because I had noticed everyone had noticed – and hence I acted almost apathetically to the danger. Moreover I assumed away my four missing details because the customer had a fine swimming stroke which created an illusion that all was under control.

That is I suspect a very human mistake…

John

The media market has a conservative bias

2009-11-07T20:23:00.001+11:00

Here is a sequence of numbers to bring tears of joy to a stockholder and tears of rage to a liberal pundit.*

197

262

211

194

249

275

282

284

289

337

330

313

379

428

429

434

495

It’s the quarterly operating profit of the cable network programming for News Corp in millions of dollars as reported since September 2005. It’s not all Fox News – but Fox News is the main driver.

I love reading Talking Points Memo, the Daily Kos, Paul Krugman and Brad Delong – but its quite clear that the mass audience and the dollars are elsewhere.

And whilst there are some nice new liberal media sites (including many I read) and I think people like Josh Marshall have reinvented part of American journalism that is all a delusion. The media market has a conservative bias.

Just to make the point further I have met a few media barons – including briefly the Sun King himself. My impression of media barons is that whilst they have political views (often quite strong ones) there real bias is to things that are profitable. Rupert is in my home town this week (Sydney) and he is personally expressing views associated with asylum seekers in Australia that are associated with the left of Australian politics. They are not views expressed in his local newspapers.

Therein is the rub. He is quite happy to have his newspapers express views contrary to his own when it sells papers. The media market determines media bias – and – as the above string of numbers show – the media market has a conservative bias and that bias is getting stronger. Media bias follows the money-making bias of media owners. People who proclaim liberal media bias are just not following the dollars.

I hope – sincerely hope – that Josh Marshall, Markos Moulitsas and others of the new media liberal elite can make a go of it. But the conservative side generates operating profits of half a billion per quarter and that gives them a longevity (and power) that the new media – for all its obvious intelligence – can only watch in gob-smacked wonder.

John

*In this case I am both a liberal pundit and a stockholder. I don’t know whether to cry or to cry.

Fannie Mae’s results – oh, and what if Bank of America reported the same way…

2009-11-06T14:44:00.004+11:00

There have been some mathematical corrections to this post discussed in the comments. My pencil notes had the numbers right. By the time I got to writing it out errors had entered. Sorry.

Fannie Mae just put out awful looking results based primarily on massive (and increasing) credit loss provisions. Indeed their provisions this quarter were the largest thus far in the cycle.

Its worth looking a little closer because – like it or not – all Americans are owners of Fannie – both the downside (their current book) and the upside (if any) through taxpayer ownership of the common stock.

The nature of credit loss provisions

Each quarter almost every financial institution takes some charges when loans they have made settle at less than 100c in the dollar. At the moment charge-offs are at historic highs.

Every quarter a company makes an estimate of future losses – a “provision” if you will.

Provisions by definition are estimates – whereas charge-offs are real and mostly final.

The difference between provisions and charge-offs goes to a “reserve for future losses” or more commonly just “reserves”.

Most financial institutions are taking more provisions than charge-offs – in other words they are building reserves. This is necessary because there are a lot of delinquencies and a lot of loans in the foreclosure process and – just frankly – a lot of loans that common sense tells you will end in charge-off.

Most institutions build reserves relatively slowly. Bank of America for instance – in broad numbers – has had 13 billion of provisions per quarter for the last three quarters and charge-offs of 6,8 and 9 billion respectively. If the charge-offs skyrocket (say to 20 billion) at bank of America then it will find itself under-reserved – and will wind up having to report very big losses. However if charge-offs slowly level off around 13 billion per quarter then BofA will – ex-post – look OK.

The honest answer in the case of BofA is that we really do not know where charge-offs will wind up but we can make educated guesses. In the last conference call BofA thought charge-offs would peak about the first quarter of 2010. If they are right then their current reserving is right and BofA is probably a steal as a stock right now. If however charge-offs continue to rise for another 18 months peaking out at say $35 billion per quarter then BofA will need to be recapitalised further and may wind up as government property.

I am inclined to think that BofA’s current educated guess (charge-offs peaking early next year) is a little optimistic – but not very optimistic and I am happily long Bank of America common shares. This is – as I stated – an educated guess. Other people I respect have different educated guesses. The (very smart) Chris Whalen has a completely different view arguing (amongst other things) that the liabilities for fraudulently sold securitisations at Countrywide and Merrill will produce losses large enough to render BofA insolvent. I think he is spectacularly wrong – but difference of opinion makes a market.

In BofA’s case 13 billion per quarter is sort of a magic number because it happens to approximate the pre-tax, pre-provision profitability of the bank. Provided actual end charge-offs remain around or below 13 billion per quarter BofA will be able to earn its way of its mess. If charge-offs go to 25 billion per quarter they can’t earn their way out – and hence just the implicit government guarantee they currently have will not be enough to save them.

I note that current charge-offs are comfortably within the 13 billion per quarter so all is well for the moment. As to the future – all we can take are educated guesses. And that is all bank provisioning is. In BofA’s case the 13 billion (plus or minus a couple) of provisions taken each quarter seems a little optimistic to me – and you can understand why when the gun is pointed at the executives head they manage to (miraculously) pick their provisions to roughly match their pre-tax, pre-provision profit. But as I have noted I think the provisions in BofA’s case are only slightly optimistic – and the end charge-offs won’t go very far above 13 billion per quarter.

Analysing the Fannie Mae result in this light

Fannie Mae – as stated - took an enormous loss this quarter. The key to this loss was a credit charge of $22 billion. This credit charge can be broken into two broad categories – which are (a) the actual charge-offs taken, (b) the addition to reserves.

Like BofA, Fannie (and Freddie and just about everyone esle) needs large reserves because – frankly losses and delinquency are still getting worse. The amount you need to add to reserves is an estimate. If your reserves are large enough (which doesn’t seem to be the case in any financial institution I look at outside the GSEs) then you don’t need to add and you might even be able to run the reserves down a little.

In Fannie’s case this quarter there is one more thing complicating the reserves versus charge-offs picture. Fannie changed the way it accounts for one of its loan modification programs (the “Home Affordable Modification Program” or the HAMP) such that when loans are acquired from securitisation trusts for modification they are written down to market. This loss (which Fannie calls a “loss on acquisition”) is not a final loss (as per a normal charge-off) but rather an estimate of the future charge-offs they would take on those loans.

So lets break up the credit charge.

The provision for credit charges was 21.96 billion – which I will round to 22.0 billion – given that the nearest 100 million seems close enough. The charge offs were 10.9 billion (see table 10 in the 10Q). Note 3 to that table tells us that of that 10.9 billion 7.7 billion came from the “loss on acquisition” on the HAMP. The actual loans that were charged-off (final) were 3.2 billion. They were probably a bit higher because there were some HAMP charges taken last quarter and maybe some were finalised this quarter.

But nonetheless the way to think about this is that final losses this quarter were 2.2 billion. Provision for future losses (HAMP losses and provision build) were 19.8 billion. Similar ratios have applied every quarter since Fannie Mae went into conservatorship.

Now I am going to make the obvious point. Bank of America provides roughly 1.5 to 2 times its charge-offs each quarter. Fannie Mae provides 7 times (and has been closer to 10 times in past quarters).

If Bank of America were to provide at the same rate its quarterly losses would be 50-80 billion and it would be completely bereft of capital – it would be totally cactus. It would be – like Fannie Mae – a zombie government property.

What I think is going on…

I think what is going on here is a different standard for Bank of America. And for Wells Fargo. And for Citigroup. And for PNC and for every other major bank in America. There is also a different standard for Goldman Sachs. That standard is different to Fannie Mae. BofA (like everyone else) gets to choose its reserving ratios – and to be a little optimistic. Fannie Mae chooses ratios that are so-off-the-scale high that it is different.

Remember provision build is an estimate not a fact – and Fannie is estimating extraordinarily bearishly and Bank of America’s estimates are slightly generous. But regulators are controlling Fannie in such a way that keeps it down. They are allowing Bank of America to act as if all is well whilst Fannie Mae appears to be a complete zombie. Which I think corresponds roughly to the new policymaker consensus that what is good for big banks is good for America.

It is clear why BofA has chosen the 13 billion of provisions per quarter – which is that it roughly corresponds to their pre-tax pre-provision income. Moreover – in my view the 13 billion per quarter is not far wrong so the decision is defensible.

It is not clear why Fannie has chosen to reserve quite so aggressively. My guess is that there is no active conspiracy – but the pressure to make extraordinary provisions at Fannie is very high for a variety of non-commercial reasons. These provisions are defensible only if you believe the housing market gets substantially worse from here. That seems to belie the evidence on the ground – at least for now. Housing markets in the core bubble states have clearly stopped deteriorating. Current provisions (including mark to market provisions on the HAMP) are now 6 years current charge-offs. They are only 18 months or so at most banks including BofA.

Am I being too harsh?

Is it too harsh to apply the same provision to charge-off ratio to Bank of America as it is to apply it to Fannie Mae? Well if the credit was deteriorating faster at Fannie that BofA I would be too harsh. But if the credit were deteriorating faster at BofA then I would be too generous. The best test of that is non-performing loans.

At year end BofA non-performing loans were 18.2 billion. They were 31.9 billion by the end of the third quarter – a rise of 75 percent.

Fannie Mae NPLs were 111.8 billion at the end of the year (20.4 on balance sheet, 98.4 off balance sheet). They were 197.4 billion at the end of the third quarter – a rise of 76 percent.

75 percent versus 76 percent – I will call that a wash.

Indeed almost however I cut it the situation is getting worse for BofA at roughly the same rate as it is for Fannie Mae.

Except for one thing. The government wants BofA alive. Lots of people want Fannie Mae dead.

My views

Bank of America survives now but for the good grace of the quasi-government guarantee. So do all banks. But Bank of America is – in my view (a view open for dispute) ultimately solvent. Its provisions are optimistic – but not (in my view) excessively so. If the cash losses per quarter rise to (say) 30 billion dollars then BofA will die and will cost the taxpayers a lot of money. I think that is unlikely but it is not impossible. Provision additions are always just an educated guess – not a science.

If the same standard were applied to Fannie Mae as bank of America Fannie would still have needed government assistance. It started with less capital and more levered than BofA. But the position would not look anything like as bad as it does.

You can of course interpret this to suggest that the Fannie Mae standard should be applied to BofA – and indeed to the rest of the financial system. You would (in my educated guess) be wrong. But I would have little ground to dispute it.

Disclosure: Long preference shares of the GSEs, long Bank of America. Could be wrong about both.

Zion sent their lawyers to get us. It is like being flogged with Jericho lettuce. I drop one on them. They can’t psychologically handle it.

2009-10-31T12:10:00.001+11:00

Oh no! Zion sent their Lawyers to get us.

It's like being flogged with Jericho lettuce!

The Feral Fundamentalists have

Come to savage us!

They must be ravenous!

Ravenous!

Meddling Mediocrity, from the Televangelist Aristocracy,

Rip off merchants from Hal Lindsey Ministries,

But Old Dozy knows when I've got 'em,

They fail to reply when I drop one on 'em.

It's somethin' they can't psychologically handle.

Them and their band of shareholder wealth vandals.*

Last week I had an exchange with Zion Oil and Gas’s lawyers. Zion it seems objected to my characterisation of the Ma’anit-Rehoboth #2 Well as dry. They accused me of deliberately misinforming the market and of stock manipulation. They threatened to report me to regulators.

I asked whether the well did show hydrocarbon flows – and if so how much? After all they have been up and down this well with equipment many times and if there were hydrocarbons they would detect gas in those trips (so-called “trip gas”). Eventually they said through their lawyers that they had found hydrocarbons in this well. (Note that their position appears to have changed since early this week – as this weeks drilling report denies the finding of hydrocarbons.)

The three letters that they sent me are reproduced here (1), (2) and (3).

Zion are currently issuing shares under a rights issue. Selectively informing me of a hydrocarbon find is of course an offense. Not informing the market of such a find during a rights issue is similarly an offence. Likewise would be failing to inform the market that the well was substantially dry. Whatever, I agreed with them the regulators should be informed. They had been keen to turn me in. So I sent them this reply:

Dear David [Aboudi – Zion’s lawyer in Israel]

It is clear that you are intending to report me to the regulatory authorities for my blog post on Zion oil and gas.

I think we should proceed quickly. I have copied this letter to Stephen J. Korotash---Associate Regional Director of the SEC office in Fort Worth in charge of enforcement. This is the appropriate regional office with jurisdiction over Zion. I have previously copied him all three of your emails to me and my blog post.

Could you suggest a time that is appropriate for a conference call?

I have not invited Tim Johnson who is the US Attorney for South Texas which has venue over Houston based issuers, however if you wish to include him his email is [withheld]@usdoj.gov

I look forward to our discussion.

Thanks in advance.

John Hempton

I have heard nothing more from them.

They drill for oil in the Promised Land. I sit at the arse-end of the earth. But good religious folk like them should know it is rude not to reply.

I am waiting for the next warm Jericho lettuce flogging.

PS. I send a draft of this post to company for comment. They have since made much clearer statements as to the hydrocarbons in this well. They are testing zones of porousity so they still have hope – but they note that:

As yet, no hydrocarbons have been ‘Produced to Surface’…

[However] with regard to our log analysis, an independent log analyst noted that the Ma’anit-Rehoboth #2 well does have a specified amount of potential “net pay”…

The analyst was careful to comment that the results of his analysis … should not be considered ‘quantitative’ due to the effects of borehole washouts on the input logging measurements used for his analysis.

He noted that the existence of any hydrocarbon-bearing, open-hole fracture porosity in the formations inferred from the effects of borehole washout on the conventional wireline log data analyzed was tenuous at best, as such reservoir properties are impossible to identify or quantify directly from conventional log data alone.

The analyst recommended testing the seven zones…

You will appreciate that, until such time as we recover hydrocarbons at the surface (or not), we are not able to give any estimates of what (if anything) we believe we may recover.

Given no hydrocarbons have been produced to the surface and the indications are tenuous at best I will now amend my original post to the well being probably dry. Their legal threats demanding I withdraw the assertion the well was dry seem hollow.

Moreover their lawyer in a letter to me (and copied to the Zion’s CEO) said:

Our client has clearly indicated in its public filings relating to the Ma’anit-Rehoboth #2 well that the well logs indicate the presence of hydrocarbons in identified 'zones of interest'.

There is an inconsistency between Zion’s latest statement to the market and their lawyers statements to me. That was a sustained exchange so the disclosure to me was not an accident. However Zion’s comments during the rights period now appear to be appropriate – I think in no small measure due to this blog.

PPS. Zion are Dallas (not Houston) based. The right USDOJ official would be James Jacks. That is good – he is probably more aggressive than Tim.

*Apologies to the former Australian Prime Minister and the master of insult – Mr Paul Keating – and Company B. The Paul Keating original is about being flogged with “warm lettuce”.

The new GSE as zero meme – laying the assumptions bare – and a modest plan for Obama

2009-10-28T16:05:00.001+11:00

There have been a few broker notes out suggesting that the GSE preferred stock is going to zero. The preferred stock itself has been dreadful lately – retreating almost to our original purchase price.

I think the broker notes are wrong – but lets do this formally because if you look at the assumptions in my model and the assumptions in the broker notes you can make up your own mind. [I will lay out their assumptions and my assumptions clearly – you decide.]

The first “GSEs are zero” broker note was produced by Keefe Bruyette & Woods (one of the few brokers left covering the stocks). I have reproduced the note here (and claim fair comment use for doing so).

The core assumption is that the GSEs are closed – and that they are put into very rapid run off – and that they do not earn much money during this run off period. Here is the revenue model for Freddie Mac.

(You will need to click all the tables in this note for details.)

There are implicitly a lot of assumptions here.

The first core assumption is that the net interest yield (after hedging costs) on the retained portfolio will be about 1 percent over the long run. I agree. In the bad-old-days Fannie Mae used to report about 120bps, Freddie Mac used to report about 80bps. When they restated their results Fannie restated the results down and Freddie restated them up. The right number was about half way between the Freddie and Fannie numbers – so 100bps is as good an estimate as any.

The second core assumption is that the short run hedged interest margin is also 1%. This is flat wrong. Fannie and Freddie are getting absolutely record interest spreads at the moment – absolutely shooting the lights out. I detailed this here. This model assumes that Freddie has net interest income of $8 billion this year – which is rather difficult because they are currently getting over $4 billion per quarter. The high current net interest margin is a function of three things:

Firstly – and most obviously – the lack of competition in the mortgage market. That is not going away in the short term – and it would be crazy to assume that net interest margins compress to 1 percent rapidly.
Secondly the Fed is being more than generous with the shape of the yield curve. That is going to end – but possibly not that rapidly.
Thirdly – and this is important – there were several charge offs of derivatives which were used to hedge the net interest margin when the businesses went into conservatorship. Those hedges are still there (but they have been written off up front rather than amortised over the life of the product). As a result reported net interest margins will be higher in the short term.

All up I would expect the net interest margin over the first two years to be maybe 12 billion dollars cumulative higher than this model. Indeed as those numbers are currently being reported it is perverse to argue otherwise.

The third core assumption is that the company is put into massive and sudden runoff. This is a political decision that – as far as I can tell – has not been made. You can see this in the numbers because the owned portfolio (and for that matter the guaranteed portfolio) is assumed to drop 20 percent per year from now. This is a far more aggressive assumption than the government is currently indicating for Fannie or Freddie. Indeed last month Freddie’s owned portfolio actually rose a little. Moreover no government official has so far indicated that Fannie or Freddie will have to get out of the guarantee business – and this model assumes that they must leave the guarantee business.

In my long series I made it clear that the value in the preference shares depended critically on the companies being allowed to stay in business – at least for a few years. That is true of the value of almost every bank in America – in that the whole sector is dependent on the pre-tax, pre-provision profits from their current business to cover their credit losses. If it were not for pre-tax, pre-provision profits even big (and sacred) companies like GE would not really be viable.

If we just assume the portfolio remains flat for three years we can add another 10 billion to Freddie’s pre-tax, pre-provision profits.

Now it is possible that the Government might choose to put the GSEs into rapid run-off (and there are Wall Street firms who crave the interest rate hedging business and who would like it) but if the GSEs are put into rapid run off it would have profound (and negative) effects for the price of conventional mortgages and for any housing recovery. I think it is reasonable to assume that they are not insane – so I think three extra years income is a reasonable assumption. However again I am just exposing the assumptions.

The fourth issue is simple double counting.

Freddie in the KBW model is assumed to write no new business. If it writes no new business it can incur no credit losses on that business.

However KBW assumes 5bps of credit losses and 5bps of credit-associated costs.

They are going to have credit losses on the old business (but they count them below). Counting additional credit losses is double counting.

It would (of course) be reasonable to assume credit losses would be incurred on new business – but KBW is asserting that there will be no new business.

The extra credit costs in the KBW model add up to another $6 billion over ten years.

I think on reasonable assumptions – including a rapid run off of the book after three years the pre-tax earnings of Freddie are thus 28 billion higher than in the KBW note. Nonetheless I am just reporting the assumptions implicit in the argument that Fannie and Freddie are permanently impaired.

Credit losses in the KBW note

There is no real model of credit losses for the existing book in the KBW note. However they do give a chart with base case, stress case and best case.

Note the cumulative loss in the best case is $33.7 billion at Freddie Mac. My model was a little worse than the best case - $37.6 billion of losses still to incur (so over 40 billion cumulative losses on the book). Since I wrote that, there has been a solid bounce in the demand for houses around the $200-300 thousand dollar mark (that is largely GSE foreclosures) in the key bubble states. This video from Jim the Realtor (who is usually a dour bear) explains just how strongly the San Diego area has bounced.

It is pretty clear from stories like this (and there are many more) that it is much easier to clear inventory. My model assumed that it was going to get much harder and that severity on the book would rise from the current 43 percent to about 50 percent.

Now this bottom-end housing bounce could be “the mother of all head fakes” – but again – like the interest margin – I am only reporting what is happening now. The housing market could take another big swan dive and then my model will be wrong. That is the bet I spelt out in the long series.

Anyway we should look at the current losses – and projected forward losses. The last Freddie Mac quarterly credit supplement gave the credit losses, provisions and reserves by quarter.

In the second quarter the cash losses on the Freddie guaranteed mortgage book were $1.907 billion. Cumulative cash losses have been a bit over 5.8 billion dollars.

My model assumes that the future losses will be roughly 6.4 times losses booked to date. That is my estimate is consistent with the housing market getting dramatically worse. The evidence for that is thin.

Not only is the anecdotal evidence (such as Jim the Realtor) pointing the other way, but foreclosures are up only 5 percent from summer to fall. Housing bears treated that news as evidence of crisis – and I thought it was a remarkably good number. The foreclosure moratoriums have expired and we are not swamped by foreclosures. My estimate that cash losses on the existing book are likely to be about 6.4 times the so-far-recorded losses does not seem low.

That said – the base case in the KBW note have cash losses being 10.1 times already booked losses. That seems unreasonably high with the strong evidence of a turn in the housing market. The stress case (which are the Congressional Budget Office numbers) are for end losses to be 24 times the amount of losses already recorded. If you believe that then depressive illness is probably the best diagnosis. Surely you should not be doing stock analysis – and it puzzles me why the CBO should be putting out such patently ridiculous estimates.

That said – KBW uses their base case in their model (59 billion of cumulative losses) and I use my base case (37 billion). There is a further 22 billion difference between my assumptions and theirs.

I note that they do not justify their 59 billion number – and I went to great lengths to justify mine. However if the housing market takes another massive turn downwards theirs (not mine) will be right. If the housing market continues to bounce (as it has) then we will both be wrong – losses will be lower than either of our estimates.

The non-mention of write-backs on the private label securities

The KBW note does not make any mention of the possibility of write-backs on the private label securities. I went to some lengths to show why – at least in Freddie Mac’s case – those write-backs were likely. I produced an estimate of about $10 billion. These write backs are reflected in part in current market prices for these securities.

This adds another 10 billion difference between my model and the model used by KBW. The total difference is thus $60 billion.

You can do a little bit better than that too – because Freddie will earn some return on the 60 billion it does not lose – but lets ignore that.

KBW’s solvency model

KBW then presents a solvency model for Fannie and Freddie. I reproduce it here:

There are some nuanced differences between my model and their. My model of losses is a model of losses not yet recognised whereas they provide an estimate of end-cumulative losses. That differs by the losses recognised to date ($5.8 billion though KBW state incorrectly that they are 8 billion). These add to the difference between the KBW model and my model.

Also Freddie Mac currently has a 7 billion dollar positive capital position (remember it made a profit last quarter and it had write backs of the private label securities). KBW has ignored that (something I consider another pure date-input error). So you could add another 15 billion benefit to Freddie on my assumptions over KBW.

Nonetheless my model of Frannie is – on fairly easily justifiable assumptions – 60 billion better than the KBW model.

Add the 60 billion to the net capital position as estimated by KBW (the –39 billion at the bottom of the table) and it is pretty clear that Freddie can repay the shortfall and make the preference shares whole. Add in the remaining 15 billion (being the chargeoffs to date and the current net worth of Freddie after profits last quarter) and it repays easily.

A plan for Obama

Reform of the GSEs is quite tricky at the moment. The jury is still out on their end losses. Moreover the ether is full of self-interested lobbyists who want to take the good bit of their business (mostly interest rate risk management) and leave the bad bit (credit risk management) with the government.

Winding down the GSEs right now runs the risk of killing the nascent recovery in the housing market.

The sensible course of action is to just wait. This is policy that can be delayed without any real additional risk to the government. (The government is already on the hook for the losses.)

If my math is right – and I think it is – then the GSEs will appear solvent in time for the 2012 election. The government can demand (and receive) almost 100 billion in capital to be repaid from them (which will make the budget look good and undermine the only viable Republican argument that the Democrats are irresponsible). It will make the government look like good conservators of key institutions. It will make Obama look like safe hands for running America.

The anti-GSE lobby knows this is a possibility and they are determined to capture as much GSE business as possible right now – so they are vociferous in their claims. Sensible people should ignore them.

John

The goldsmith as retail bank

2009-10-22T14:51:00.001+11:00

The parable of the evolution of private banking comes about with a story about a goldsmith. The goldsmith has the strongest safe in town – so people deposit their gold for safe keeping. People consider the certificates of deposit equivalent to gold. The goldsmith however lends the gold in the vault for a fee. That is real gold. And thus banking acts as a gold multiplier.

These days of course it happens with paper money. I have never borrowed gold – and nor has anyone in my usual social acquaintance.

But I am not Indian.

Extracted from the State Bank of India annual report:

Gold Banking

• The Bank has taken several initiatives to undertake bullion business in a big way.
• The number of branches for retail sale of gold coins has increased from 250 in 2008 to 518 in 2009. The Scheme will be extended to cover all important centres of the country in 2009-10 by increasing the number of branches selling gold coins to about 1100. The Bank also undertakes supply of customised gold coins to corporates.
• The Bank has re-launched Gold Deposit Scheme at 50 branches to mobilise gold from domestic market for deployment as metal loans to jewellers.
• The Bank is in the process of setting up a dedicated Bullion branch at Mumbai to undertake bullion business in a focussed manner.

Whatever pleased the Lord, he did, in heaven and on earth, in the seas, and all the depths…

2009-10-16T21:34:00.002+11:00

After considerable exchange with Zion's lawyers I have amended this post. The well is "probably" dry. For an explanation see this post.

For a small exploratory oil company with limited funds a dry well is really bad news. Three dusters and it is game over. Two and – well – you probably should be looking elsewhere.

And so I want to report to all that Zion Oil and Gas has had a probably dry well.

Zion is a special company drilling for oil in a special land. An alliance of fundamentalists Jews and fundamentalist Christians are fleecing their flock with a string of rights offerings to fund drilling in essentially non-prospective land in Israel. The company’s promotional dross is simply funny. This you-tube clip is simply a gem…

Zion however has reported the main well they were drilling to be dry. But – even funnier than the video is the press release announcing the bad news.

Enjoy.

25 September 2009 – Operations Update # 20

As noted last week, we have successfully drilled this well to a depth of approximately 17,913 feet (5,460 meters).

This past week, we ran a ‘velocity survey’ in order to help increase our understanding of the geology of our license area.

A ‘velocity survey’ is a type of seismic survey where the seismic travel time from the surface to a known depth is measured. Geophones are lowered into the wellbore and a pulse wave sent out from ground level; the resulting signals are then recorded.

The velocity survey data will be used to correlate specific formations to reflections seen on the seismic sections that we used to map the Ma’anit structure.

We have decided, for the present, not to drill any deeper in this well and are now analyzing and establishing the priorities of the seven zones that warrant completion testing. However, the well bore is in excellent condition and it is possible that we will drill this well deeper in the future. Next week, I will comment further, but I’ll mention that this week Zion’s Chairman, John Brown, gave me a note with the reference Psalm 135:6 – ‘Whatever pleased the Lord, he did, in heaven and on earth, in the seas, and all the depths…’

Are the Spanish banks hiding their losses? Looking at the American data

2009-10-05T19:16:00.001+11:00

Whether the Spanish banks are hiding their losses is a major debate going on in the blogosphere and has been detailed at length in the Financial Times. The stakes are very high – this is a debate about the stability of the Eurozone and possibly of Europe itself.

Background

I have a lot of American readers whose interest in finance stops at the American border. I need to outline what is going on.

Spain had a monstrous building boom – a building boom on (at least) Californian standards based very much on coastal development. The building boom has slowed considerably. The building boom attracted relatively unskilled labour – as building booms are apt to do – and about 40 percent of all migrants to EU settled in Spain. Wikipedia (I wish I could read the original Spanish source) state that the foreign population in Spain has gone from about half a percent of the population in 1981 to over 11 percent recently. This change in racial mix has resulted in only minor tensions (with the possible exception of the large terrorist attack in Madrid).

The financial crisis has hit Spain hard. Unemployment is about 20 percent – though this overstates the GDP contraction. A lot of the new immigrants are now unemployed.

Twenty percent unemployment would normally result in large bank losses – indeed you would expect bank insolvencies. However this has not happened. The two giant Spanish banks (Santander and BBVA) appear amongst the most profitable in the world and have substantial market capitalisation. Strangely Spain looks solvent despite its apparent economic catastrophe. Part of the explanation might be that the economic problems in Spain fall mainly on the newer immigrants and the unskilled end of the labour market – and that these people are not the loan customers of the bank. In this formulation the Spanish recession is about the same depth as the American recession – and the 20 percent unemployment rate is just an artefact of the migrant economy.

Either way both big banks are depleting loan reserves (at least compared to delinquency and non-performing loans). But both banks are reporting low losses and low loan arrears.

The banks however could be lying.

The stakes are enormous. The bears (led by Spanish resident Economics Professor Ed Hugh and the financial research house Variant Perception) argue that the Spanish regulators and banks are conspiring to hide Spain’s insolvency – and when Spain turns out like Argentina either the European central bank (that is the old German central bank) will bail out Spain at great cost to the Central Europeans or the European monetary experiment – and possibly the whole European political experiment will be challenged as Spain fails economically and socially. It’s alright to bail out Latvia after its economic disaster. Latvia is small. Spain however is large and important in a European context. Ed Hugh would argue that it is best to deal with the problem now – because delayed it will get much worse.

Do not for a minute think that the stakes here are overstated. Full blown economic collapses (eg Latvia, Iceland, Argentina) usually lead to riots and governments falling. Where ethnic tensions run high those riots often have a racial element (rioting crowds find scapegoats). Europe can paper over the Bronze Solider riots in Estonia (which pre-date the crisis). They can paper over riots in Iceland and Latvia because the economies are small. But an economic disaster in Spain would pose major difficulties – difficulties I think European Union would survive – but which would stress the system to its core.

To be this bad though the banks would need to be hiding their losses on a grand scale. Most banks in crises hide a few losses (and spread them over time). However the bears are truly apocalyptic. The Variant Perception report is an absolute classic of hyper-bearishness. If it really is that bad then either central European taxpayers are going to be stuck with a huge bill or the core political union in Europe is vulnerable.

Less worried folk have pointed to inconsistencies in both Ed Hugh and Variant Perception’s data analysis. An ordinary level bank failure could be dealt with by Central European taxpayers with only minor stress – however if you believe Variant Perception we are not looking at an ordinary level collapse – its way bigger than that. Ibex Salad – a blog with the unlikely topics of the Spanish Stock Market, Spanish Economy and the olive oil business is the counterpoint to Ed Hugh and Variant Perception.

The data is mostly ambiguous – as the bears would argue – the data is largely faked anyway – finding inconsistencies in the data is to be expected. They would argue that common sense – and the overbuild visible when you open your eyes – indicates that there is a serious problem here.

I really do not know. I am not close enough to the ground in Spain to know – and – frankly – analysing (supposedly) faked data in a language I can’t read from a desk in Australia is unusually difficult. But there seem to be four variants.

(a). The Spanish banks are telling the truth – and this is a storm in a teacup,

(b). The Spanish banks are doing a normal amount of bank over-optimism in the face of a crisis – and whilst the banks are really stretched (but not telling us) the banks are ultimately solvent – and the European experiment is fine,

(c). The Spanish banks are in fact diabolical – and the losses are maybe 15-20 percent of a year of Spanish GDP – in which case a bailout by (effectively) German taxpayers is possible or

(d). Variant Perception is in fact unreasonably bullish – and Spain will collapse economically and socially and we will be thankful if all we get back is someone like the Generalissimo. The modern European experiment will be deemed to fail because a single European Union with a single currency can’t hold together in a crisis because Germany won’t or can’t bail out Spain, Italy and Greece in a crisis.

Instinctively I am in camp (b) above. However I acknowledge all of the above are possibilities.

Migration, racism and currency union

I am going to do a little further explaining of the stakes here. The threat to currency union in Europe always was ultimately racism.

When you have currency union you can no longer have a high interest rate in Spain or Italy (when those economies warrant a high rate) and have a low rate in Germany when Germany is recessed. You have a single interest rate across the currency zone.

The underlying state of most of the past 15 years was Spain booming, Germany mildly recessed. Currency shifts or shifts in value between the Deutsche Mark and the Peseta can – by dint of currency union – no longer happen. The main mechanism of economic adjustment is removed.

America has always done that. The same interest rate applies in the rust belt, in the sun belt, in California and in Boston. And we know how economic adjustment happens. Americans move. A vast number of Americans do not live in their home town and the bulk of the world’s busiest airports are American. Internal American migration is massive.

However migration within Europe has always involved more issues. The languages are different. Several countries have histories of nasty endemic racism. There are large cultural barriers.

Monetary Union – whether by design or just outcome was always going to confront those barriers. And it was always going to be slow. There is a reason why the German/Spanish imbalance was so long lasting last decade – which was that it is much harder for a German to move to Spain than it is for say a Hoosier to move to California.

The changing racial mix of Spain throughout the boom seemed to show that massive shifts in racial mix and massive internal migration could be accommodated without the tensions of Europe’s dark past. They were the embodiment and a proof of the European political experiment. If Spain collapses beyond bail-out (as per Argentina) then monetary union is over – and economic union with racial harmony will be challenged.

As I said – the stability of Spain is a big issue and the crux point is the losses in the Spanish banking system.

The Spanish American data

Sitting at my desk in Bondi Australia I have no real advantage in answering the big questions about the solvency of Spain and whether Spain really is the black hole in Europe’s balance sheet.

But I can add to the debate. The Spanish banks have American operations – and using reasonable comparisons we can work out whether the Spanish banks are hiding their American losses. So far I have not seen any analyst do this – but it is surely worthwhile. I am going to focus on BBVA because I once had a detailed understanding of their American operation (Compass).

Several years ago BBVA paid a premium to buy Compass to form BBVA Compass.* This is how they describe the bank:

BBVA Compass is a leading U.S. banking franchise located in the Sunbelt region. BBVA Compass is among the top 25 largest banks in the U.S. based on deposit market share and ranks as the third largest bank in Alabama and the fourth largest bank in Texas. Headquartered in Birmingham, Alabama, it operates 579 branches throughout Texas, Alabama, Arizona, Florida, Colorado and New Mexico

This bank files US statutory filings (better known as “call reports”). There is no reason to presume that the Spanish regulator is conspiring with American regulators to fake the accounts of a bank headquartered in Alabama. Moreover there are other sunbelt banks to use as comparisons – whereas in Spain you can only really compare BBVA to Santander – and the bears would argue that there is no point checking for faked data by comparing it to other faked data.

If BBVA is telling the truth in America then there is a reasonable chance they have a culture of truth telling. That would suggest that they are probably telling the truth in Spain.

However if BBVA’s American accounts are riddled with deception (or at least an overly-optimistic prediction as to their losses) then it is likely that BBVA has a culture of understating losses – and that that culture extends home to Spain.

Of course the truth could be (and I would normally expect the truth to be) somewhere in the middle. A little bit of excessive optimism is normal behaviour for a banker in a crisis. But a little bit of excessive optimism does not imply bank or national insolvency – just some difficulty. The European experiment can survive that.

So what does the BBVA Compass call report say? Is BBVA hiding its American losses? If so – how bad loss hiding culture.

I have posted the key Call Report to Scribd.

Here is a a comparison – comparing BBVA USA ratios to a sample of similar bank holding companies chosen by the FFIEC. (You will need to click for the complete picture with all three tables in this post.)

The instant conclusion is that BBVA has higher delinquencies than the competition but has lower loan loss provisions and is charging less off than the competition. This conclusion is robust almost no matter how you cut the BBVA USA data. I think we can safely conclude that BBVA is hiding its losses. If anything it is slightly worse than the above indicates because nobody in their right mind thinks that the comparables (larger American regional bank holding companies) are honestly stating their losses. But if the comparables are understating losses then BBVA is understating them more.

This puts me firmly into camps (b), (c) or (d) above. The question is no longer whether they are hiding the losses – but whether the scale of problems (in Spain) is sufficient to cause major political ructions or whether it is just an issue for the stock market. [Disclosure: I am short BBVA and the position is modestly painful as the stocks have appreciated.]

How are BBVA hiding their losses in America?

There is a time honoured way of hiding losses in banking – a method that Variant Perception suggests is being done on a breathtaking scale in Spain. The method is rather than call a bad loan bad – to just extend it a bit more credit. If the borrower can’t pay the interest give them a bigger loan or line of credit. They will use the loan to become current. The slogan is that a “rolling loan gathers no loss”. Even the most diabolical subprime mortgage book in the US showed only small losses until the market stopped rolling the loans.

We have some evidence that BBVA is rolling bad loans. Here is the loans outstanding by sector (again you will need to click for detail):

The level of rolling loans is not at the alarming levels that Variant Perception alleges are present in the Spanish economy. Then again Alabama and the other states in which Compass is large do not have 20 percent unemployment. The aggression which BBVA grew the book in the past five years however is breathtaking. You can see where all that Spanish risk comes from and why Spain had such a monstrous property boom.

Construction loans – a perspective from the American book…

The main allegation in the Variant Perception report is that the Spanish banks are massively overweight construction loans – and that they are extending those loans rather than allowing default. The core statistic is given in the following paragraph:

Consider this: the value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That's almost 50% of Spanish GDP.

They add that they think that most of those loans will go bad (which implies a Spanish crisis many times worse than America – and implied bailout requirements that are similarly bad).

Construction loans at almost 50 percent of GDP is a truly astonishing figure. The entire US mortgage market is roughly 10.4 trillion dollars – or about 75 percent of GDP (and as the crisis has shown that seems too large). The idea that construction loans are nearly 50 percent of GDP had me falling off my chair. I tried to confirm this figure (as it felt like garbage). Alas I could not. However Iberian Securities has done some legwork:

Variant picks-up a classic wild-card to spice-up the report. Specifically, they say most of the €470bn in outstanding loans to developers/construction (50% of Spain’s GDP) could go bad. The report forgets to mention- however- that a chunk of the €32 bn in outstanding loans to developers does not necessarily involve residential lending but commercial lending (which is relatively safe in Spain , in our view). It does not say either that a not-low percentage of construction activity in Spain involves public works, so a proportion of the construction-related debt (€141bn) should be attached to that public sector accordingly. Also it is worth considering that residential work-in-progress in Spain — one of the biggest contributors to the €320bn figure — is generally collateralized (with Spanish major developers reporting LTV of 50-65% approx). Factor-in these and the final loss on this portfolio should be a fraction of what Variant claims. In our models, we assume a 15% peak NPL ratio on Developers (7.6% in 1Q09) and a 10% NPL ratio on Construction loans (6.7% in 1 09).

Even at 6.7 percent of GDP construction loans are too big relative to GDP and the time in the cycle – but they are not big enough to cause problems for Spain. I still cannot reconstruct the data to get construction loans that small in Spain. There are over 600 thousand homes under construction in Spain – and most of those are financed. Add the finance on those loans to other easily identifiable construction loans and you get over 10 percent of Spanish GDP. I am not confident with the Iberian Securities estimate.

However we do get clean numbers in America for BBVA’s subsidiary – and it is clear that they are into construction loans in a fairly big way – and that their construction loan book is not good and they hiding the losses.

Here is the composition of BBVA’s American lending book versus its American peer group.

Its pretty clear that BBVA USA is not afraid of construction loans relative to peers – and – on the evidence presented here – is probably rolling them (and hence deferring losses). This is nothing like the scale alleged in the Variant Perception report but it suggests that the basic Variant Perception allegation of hiding construction losses is more likely than not to be true.

I should note that the construction loans are 10.64 percent non-accrual (which is slightly less than peer). It seems unlikely you would willingly be expanding lending in this category with those credit statistics. Its far more likely that the company is hiding losses by rolling non accrual loans.

A note on scale

All these problems of the same type that Variant Perception alleges in Spain – but none are of the scale Variant Perception alleges in Spain. In other words I can unequivocally support the notion that the Spanish banks are hiding their losses – but support for the notion that these losses are so large that France and Germany will be left “holding the bag” is not to be found in the US data.

What the Spanish bankers have been telling us about their credit is – at least on the American data – easily shown to be lies. We just don’t know whether they are big lies.

For the sake of Europe I hope they are not.

John

Post script: I have linked to a few blogs here – but the important ones are Ibex Salad, and A Fistful of Euros. These blogs disagree with each other – but they are of the highest quality. If you are interested in this stuff then put them on your blog roll.

*A few disclosures are necessary here. All the key players in the blogosphere debate (hyper-bears and moderates) are my “Facebook friends”. In this day-and-age you don’t have real friends – just computer friends. I do not know what they will think of me after this post. I expect disagreement and I will post follow-ups. Some I am sure will disavow my “friendship”.

Second - at Bronte we have a small position short the Spanish banks – it has not been profitable. Moreover we are deliberately short them on the US stock exchange – which means we are short the banks long US dollars. That has been particularly bad of late because the US dollar is weak. However in a true crisis the Peseta (and yes I mean the Peseta) will be really weak – and we would rather be short them on a US listing where the cash balance is held in US dollars than on a Spanish listing where the cash balance is Euro converted into Peseta at an unfavourable exchange rate.

Just like with Charter One – BBVA caused me more than a dose of heartache. I was short Charter One when Sir Fred Goodwin and his RBS idiots came and purchased it at a massive premium. That was the single worst day of my career. Similarly I confess to being short shares in Compass when BBVA bid for them (admittedly for a much smaller premium). Nonetheless, it was – as they say – not a good day at the office.

Finally it is a long weekend public holiday in Australia. You can tell a nerd when he writes 3350 words on Spanish banking when he is meant to be on holiday.

Ducks in sewerage treatment works, drug resistance, dumb luck and investing

2009-10-02T16:34:00.001+10:00

The day the swine flu story broke in the global press I wrote up for the blog a possible influenza hedge. It was a stock I thought would make money – but I did not really want to win big on. It would be nice to profit – but not because of mass influenza deaths.

Biota Holdings is an Australian small-molecule drug development company whose core asset is that they own a 7 percent royalty on all sales of Relenza. Relenza is a distant number two influenza antiviral drug. As explained in the original post the drug is taken through a “turbo-inhaler” which is less marketable than a tablet – but more marketable than an injection. The difficulties taking Relenza meant that Tamiflu dominated the market.

The story I posted was nuanced and accurate. It was only possible to write that story because I had followed Biota before the Swine Flu outbreak and had been considering purchasing the stock anyway. Swine Flu forced the decision.

In our quarterly client letter I wrote a follow up story which I think deserves a wider circulation.

Firstly our clients were really lucky. Whereas personally I purchased the stock the day the swine flu outbreak happened our clients purchased a few weeks later. Why? Because we could not purchase the stock for them until we received our Australian Financial Services License. The following graph shows the advantage that they received:

The lower purchase price (dumb luck) meant the clients purchased more. The very strong Australian dollar has meant that our US based clients have well over doubled their money.

The luck continues

Tamiflu drug resistance (something alluded to in the original post) turned out to be the critical ingredient in the story. It has both policy and investing implications.

In Japan, where Tamiflu is widely prescribed, the active compound (oseltamivir carboxylate) is excreted by the body (in urine) or is activated by the biological processes at the sewerage treatment works itself. Water at and downstream from the sewerage treatment works is high in oseltamivir carboxylate. That is really bad news because birds (especially ducks) like to bathe in the nutrient rich waters. Those ducks are the hosts in which new influenza viruses breed – and because the water is rich in antivirals the Japanese are breeding new strains of Tamiflu resistant influenza. This is not good news because the US government and other drug stockpiles are heavily weighted to Tamiflu – and there is a reasonable chance that the next global flu epidemic will be Tamiflu resistant.

Whilst that is not good news for the world – it is wonderful news for Relenza sales and hence our clients’ position in Biota. And it is nothing that we anticipated. If you told me my blog would wind up being about ducks in Japanese sewerage works I would have laughed. From the perspective of our clients it is plain luck – but that will not stop us profiting from it.

Luck is pervasive in the investing game. We did not figure on Tamiflu being a serious environmental pollutant. It was just as likely that Relenza would be a pollutant. Then, rather than showing profits we would be explaining losses to our clients. A story about ducks in sewerage treatment works causing us losses would not sound plausible (even if true).

Anyone with good investing results who does not admit to a dose of luck is lying. The world is a complex place – and I would never have guessed that ducks in Japanese sewers had anything to do with our portfolio.

The new rapid SEC

2009-10-01T07:15:00.001+10:00

Mary Schapiro has not got great press amongst financial bloggers – however this time she beat me to the punch.

Emergent Health Corp was a heavily promoted pink-sheets biotech which (fraudulently) claimed to have a pill (yes a simple oral pill) that would stimulate the production of stem cells in adults and hence cure everything from paraplegia to heart disease to leukaemia. Here is just one of their press releases:

Emergent Health Corp. (Other OTC:EMGE.PK - News), a diversified holding corporation focused on the biotechnology sector, announces the Company has received approval from the U.S. Patent and Trademark office for their adult stem cell nutrition product Neuvitale(tm) Life Support.

An Emergent spokesperson commented, ``The Company is pleased to announce a license to market a formulation with ability to increase adult stem cells naturally from a person's own bone marrow has been allowed by the U.S. Patent and Trademark office. Now that this patent has been allowed, Emergent will seek further corporate and joint venture opportunities with firms capable of assisting entry into this untapped estimated Multi-Billion dollar market currently dominated by drugs with high costs.''

By 2004 the world market for Colony Stimulating Factor products, Neulasta(r) and Neupogen(r) marketed by Amgen was valued at $3.6 billion, a growth of 11% over 2003. That market has grown at an average annual growth rate of 16% over the previous 5 years. This is cited only as a market size barometer.

In addition to this product, the Company is actively exploring additional investment projects involved in the adult, umbilical cord, and embryonic stem cell sector to add to its growing portfolio of biotechnology ventures.

On these press releases the stock popped rising from about $1 to about $4.

The claims were outrageous of course – but you can still buy their products online. Some of their online adverts make equally outrageous scientific claims. Others – like this YouTube video – have a disclaimer at the end.

I tried for the last few days trying to find a borrow – any borrow in the stock. [You need to borrow the stock so you can short sell it.] Apparently there was a borrow on Monday but I was on holiday – and so I never managed to short the stock. [I was planning to donate the profits to charity.]

After that I was going to write a letter to both the Food and Drug Administration and the Securities and Exchange Commission and see which organisation shut this fraud down first. It was going to be an uncontrolled experiment to see if the SEC could live up to Mary Schapiro’s promise to be more responsive.

Alas – and this is good news for America and bad news for my favourite charity – the SEC acted fast on this one. They just suspended the shares in EMGE.

Whilst Mary ~~Cox~~ Schapiro is dragging her feet on a much bigger fraud I have shown her I got to give credit on this one. The SEC did this quicker than they ever would under Mr Cox’s ~~stewardship~~ failed regime.

The SEC has only civil powers. EMGE rises to the level of criminal fraud. This improvement means nothing if the prosecutor can’t back up. And therein lies the next set of problems.

Politics makes people believe the strangest things – so let’s try make money from their stupidity

2009-09-19T14:21:00.001+10:00

I knew I was stepping into heavily political ground when I wrote my impressions piece about Australian semi-socialised medicine. Most responses (including emails) were reasonable – but some were so ideologically blinkered as to be perverse.

On the right there was much selective looking at data to argue that America does not produce (in aggregate) relatively poor health outcomes for the dollars spent. You can pick individual conditions and show America is better-than or worse-than average. But any reasonable overview of the American system will come to what I think is a non-exceptional conclusion.

On the left there were several people who argued that pharmaceutical research done by capitalist drug companies was simply not important – citing the development of cosmetic and “me too” drugs and ignoring substantial research. They argued real medicine is done by governments and universities – in other words good research is a socialist or semi-socialist activity. That is simply blinkered. One of my close friends – who has spent his adult lifetime doing cutting edge genetics research for profit (and who grew up under Chinese communism) simply responded that there are plenty of people who still believe communism is a good idea.

Anyway one of the things that is patently obvious about America and its stock market (at least looking from Australia) is that it produces fantastically innovative companies. American Capitalism gave us semi-conductor capital equipment producers, Google, the planes that enabled cheap commercial jet travel and mass marketed chewing gum. More than a few of these involve some research. Even the most cursory look at the product set of Amgen – a major drug company – would suggest that American capitalism funds some impressive drug research.

Strange views like these exist in all countries – but the extent to which irrational right wing views are not controversial in the right and irrational left wing views are not controversial in the left is hardly a recommendation for America’s democracy. (Americans call it polarization.) The question is what are you going to believe: the prima-facie thing that is consistent with your ideology or your own lying eyes?

At the moment ideological belief that is inconsistent with reality is (far) more pervasive on the right as seemingly serious right wing politicians pander to Rush Limbaugh’s lack of nuance or to anti-scientific creeds such as creationism. But it is not always going to be that way – and some of the responses to my post suggest that there is a latent left wing Limbaughism too.

But this is just tearing wings off butterflies. There are plenty of stupid and/or ideologically blinkered people out there. Pointing them out has about the same level of charm (and general interest) as making fun of “creation scientists”.

I write an investment blog – and I have no reason to be interested in where commentators in the blogosphere are demonstrably wrong because they argue from their ideology rather than observable facts. I have a really big interest – a money making interest – in where people are wrong in markets because they rationalize from ideology rather than observable facts. These things happen – for many years market driven ideologues thought that the securitised mortgage market was fine because it was done by private sector participants (and it mostly dealt in mortgages that Fannie Mae and Freddie Mac were prohibited from dealing in). They were wrong. Anyone who hung out with a half dozen mortgage brokers and saw the trash they were underwriting could have (and should have) worked out that this was a disaster. Ideology trumped facts on the ground. And it gave some stupendous money making ideas. People made hundreds of percent returns on their money shorting the AAA strips of CDO squared securitisations and other high-finance dross. I know someone that made billions (yes billions) of dollars betting that subprime lending would end in a crisis – and they only had to risk tens of millions of dollars to make that money. Stupid ideology gave huge profit potential. That stupid ideology came from the right because at the moment there is (much) more stupid ideology on the right – but again it was not always that way and will not always remain that way.

So – here I am begging my readers. Much as I like reading about creationist astronomy and postmodernism and the Sokal Hoax and other people made stupid by their ideological blinkers - I would prefer find market sensitive stupidity. If people can reply with ideas and the easily observable facts that prove them wrong I would be thrilled. Emails acceptable. But please no argument based on your ideology versus their ideology. I am only interested in argument which is “their ideology versus readily testable fact” and then I am only interested if we can make money out of it.

John

PS. Don’t mention Zion Oil and Gas. I have already covered that one.

Hoisted from the archives – my old post on Freshwater and Saltwater macroeconomic theory

2009-09-17T12:52:00.001+10:00

Long before Paul Krugman elevated the central schism in macroeconomics to the front page I wrote about it on this blog.

My old post is reprinted below (with a few trivial modifications to make it more readable than the original):

Freshwater and Saltwater: macroeconomic theory and losing money

Background for the non economists. In 1976 Robert Hall christened the central schism in macroeconomic thought as being between the freshwater and saltwater schools. The division was picked by their location (on the Great Lakes and Rivers versus the coastal schools). The division exists today – and indeed is being played out in Krugman’s (saltwater) blog and by the Chicago economists who think he is a bozo idiot.

Having got through the background here is the post…

Does everyone agree that Greenspan kept monetary policy too loose for too long?

I thought so!

When I did economics at University (admittedly at that Freshwater school on the Molonglo River called the Australian National University) that was meant to end in inflation – not deflation.

I like my theory to accord at least loosely with reality. Especially if I am going to bet real money on the outcome – rather than pontificate in papers from the ivory tower of academia.

More to the point – I thought (in true Freshwater style) that sustained low interest rates were a sign that monetary policy had been tight and that sustained high interest rates were a sign that monetary policy had been loose.

Given that basic understanding of macroeconomics I thought that regional banks that made more than half their profits out of carrying the yield curve would be carted out when loose monetary policy did eventually lead to higher interest rates. I was short a lot of banks – and whilst that was good – I spent a long time being short interest rate plays (whereas I should have been short the credit sensitive banks). I have detailed that mistake here. Bill Gross made a similar mistake declaring (early) the 25 year bull market in long dated treasuries over – so despite Bill Gross’s saltwater location at Newport Beach I was wrong in good company.

Now the subject of freshwater, saltwater and other macroeconomic elixirs is the subject de-jour amongst economic bloggers – but I have conducted the experiment – with real money – and I can confidently say (brutally backed by less-than-ideal-financial outcomes) that the saltwater guys were right.

John Hempton

PS. I know that the inflation junkies are still predicting hyper-inflation – but they were also predicting it in January when I wrote the original post. The Freshwater guys are still wrong. Will the backers of the Freshwater school please put out a testable timetable?

PPS. A reasonable summary of the issues I lived can be found in Justin Fox’s book. Whether Krugman should have referenced Fox in his magazine article is an open question – but I think Fox’s summary is right… Krugman lived the issues in the book and did not need Justin Fox to explain them to him…

Vested self interest and the future of Fannie Mae and Freddie Mac

2009-09-13T19:31:00.001+10:00

Fannie Mae and Freddie Mac take credit risk and interest rate risk.

They take credit risk primarily by guaranteeing mortgages.

They take interest rate risk primarily by owning mortgages and financing them on their own balance sheet. They also trade the interest rate risk of that book using derivatives.

The anti-GSE lobby always asserted (and I once erroneously believed) that Fannie and Freddie Mac would come to grief on their interest rate risk. Taking interest rate risk is what the once-extensive anti-GSE lobby meant by charter creep.

Well the anti-GSE lobby were wrong. So was I. Fannie and Freddie did not blow up on interest rate risk – they blew up on credit risk. Mainly they blew up on credit risk from non-charter mortgages but they still have had no noticeable interest rate problems during this cycle.

The Anti-GSE lobby always had an agenda

Wall Street always hated Fannie and Freddie taking interest rate risk – it encroached on the profitability of Wall Street trading desks. Trading interest rate risk is the core business of Wall Street trading desks – and they hated having GSEs (with funding advantages) crowding them out of their own game.

But Wall Street loved Fannie and Freddie taking credit risk – that meant that Wall Street could splice and dice mortgages all they like – and know that eventually Uncle Sam will pick up any credit losses.

So they always pushed for limits on the interest rate risk that the GSEs could take. I never heard FM-Watch or other anti-GSE lobbyists arguing for limits on GSE credit risk acceptance.

When the anti-GSE lobby now say “I told you so” they are lying. They said the GSEs would blow up on interest rate risk and they were wrong – but they are falsely claiming intellectual credit anyway. It helps their lobbying.

So how do the proposed reforms of Fannie and Freddie look?

All public proposals for GSE reform have the same feature. They all allow Fannie and Freddie (or their replacement entities) to stay in the credit risk business by guaranteeing mortgages – but they insist that Fannie and Freddie shrink their balance sheet – and hence take less interest rate risk.

In other words they leave all the credit risk with the GSE – solving nothing from a taxpayer perspective and give all the interest rate carry (and most the revenue) to investment banks. They do nothing to solve the problems that caused the GSEs to fail.

That is also the structure of the conservatorship agreement by Hank Paulson forced the GSEs to sign – an agreement constructed by the staff of Morgan Stanley. The agreement gave Wall Street precisely what it wanted – which is not surprising because it was drafted by Wall Street investment banks.

The Mortgage Bankers’ Association proposal is even more egregious – but that is the subject for another post. Even the Government Audit Office report leans heavily towards the wishes of investment bankers. (You would think they would be better than that – but it seems they are only as good as the people lobbying them.)

So here is a hope for the Obama administration. Be very sceptical of the the vested self-interest behind anyone making GSE proposals. [Whilst that includes me I am just shooting from the sidelines. Investment bankers drew up the conservatorship agreement in the interest of investment bankers. That sort of power should not go unchecked in America.]

Fannie Mae and Freddie Mac – closing the modelling sequence

2009-09-11T11:24:00.000+10:00

The last post – which was incredibly difficult to write – received remarkably little comment – and almost no feedback. So I am going to close the modelling sequence early – and write a few posts about the politics of Fannie Mae and Freddie Mac as standalones. Almost all the proposals for “reform” seem to leave most of the credit risks with the government and give much benefit to Wall Street bankers. That includes the original proposals implicit when Paulson – the once King of Wall Street – put them into conservatorship. I will later expose those for the vacuous positions that they are. I want to write the politics sequence so you do not have to have closely read the modelling sequence – because I know these will appeal to different audiences.

But for now I will note that most the well-informed comment has indicated that I have underplayed the role that tax losses have played in putting Fannie and Freddie into the position they are. Certainty as to their future will enable them to write back the charges against tax assets they have taken. 18 months of profitability (which they will have) plus some certainty to the future will allow approximately 30 plus billion dollar write backs at both GSEs. That will leave the GSEs with positive net worth (and able to repay government loans) in time for the 2012 election. I will leave that to the politics sequence.

I said in the first post that I will close with a comment that was once left on my blog by “Bondinvestor”. This was the only comment I have ever censored because it stole my thunder… here it is… [with annotations in square brackets and blue colour]. I pleaded on the blog for Bondinvestor to contact me – but with not much luck. Bondinvestor summarises my arguments quite well – though I think the same applies to Fannie Mae – albeit with less force.

You should take a deeper look at FRE. it was a very well run company before the crisis - and not just on the portfolio side. [I was – well before Bondinvestor left this comment.]

Look at their credit statistics. the 90+ delinquencies are high relative to history, but far below the rest of the industry - as well as Fannie Mae. [I noted this in Part III.]

The tragedy at Freddie is that they purchased non-agency AAA MBS in an attempt to meet their housing sub-goals. [I noted in Part II that the losses came primarily from the Private Label Securities.] Their calculus was that the inherent subordination in the AAA's would protect them in a credit Armageddon. [Well we got credit Armageddon and the Private Label Securities business did cause huge losses for the GSEs.]

What is fascinating about FRE is that the jury is still out on what the actual realized losses in their non-agency book will be. The AAA private label pass throughs that the agencies bought were specially designed for them. The balances were all conforming; the pools had lower CA/FL concentration than the rest of the non-agency universe; and - most interestingly - the loans underlying the GSE's AAA's were segmented from the AAA's that were sold into the public market, though they shared the same subordinate tranches. what this means is that catastrophic losses in the Type II bonds do not necessarily imply catastrophic losses in the Type I bonds (the GSE-eligible AAA's). [Analysing this was the point of Part IX. They will incur losses – just nothing like as bad as they provided for.]

If you go look at remit reports, you'll see that the delinquencies underlying the agency-eligible bonds are much lower than the DQ's underlying the non-agency bonds. [Actually I have done so – and whilst the DQs are lower in the agency-eligible pools they are not much lower. The biggest advantage that the agency eligible pools have going for them is that they retain far more excess collateral against their delinquencies.]

Now, part of the problem is that the atrocious performance of the non-agency pools will eat up the subordinate tranches, thereby depriving the GSE-bonds of their fair share of the enhancement. [They have almost entirely done so in the series I analysed in Part IX] but, given the relative performance of the loans underlying the GSE bonds, it may not matter. [It will matter with respect to the series that I have looked at – but the excess protection in the agency-eligble pools means that the GSE losses will be under half the losses incurred by the AAA strips of the non-agency eligible pools – in many cases less than 15 percent of the normal AAA losses.]

Anyway, all this is a very long winded way of saying that the actual realized losses in Freddie's $150B portfolio of private label MBS may not approach anything like the huge mark they have taken on this book (and which destroyed their capital base in the early innings of the credit cycle). [Freddie thinks about 30 billion will reverse as described in Part IX – I think it will be less – but I am having a very sophisticated conversation with one reader who thinks it will be more – and provides modelling to prove his points… I think I could be twisted to agree with him – and will put up a technical post if we (jointly) ever get around to writing it…]

I know folks inside FRE who think that the "shadow equity" that comes back on the balance sheet as the PLS portfolio pays down is on the order of $70B. that is more than enough to retire the convertible preferred note the government took as part of the conservatorship. [I know no such folks. I worked this out on my own. But I think the shadow equity is closer to 50 billion – say 25 billion that will reverse on the private label securities and the other temporary impairment plus about 30 billion in tax losses but less the 10 billion or so more reserves I think they need to take over time on the traditional business.]

Now, none of this is to say the losses on the guaranty book won't be large. but the company discloses enough information to come up with a reasonable estimate of what they could be. You just have to look at the 06/07 vintage curves and make a judgment about how long it will take those books to season. the realized cumulative losses will most likely be somewhere between $30 and $50B. they already have a loan loss reserve of $22B. so they have some wood to chop, but it's not an egregious amount. [Well I did that modelling in Part VI. I agree with the numbers Bondinvestor comes up with – actually I think the end losses will be less.]

A much bigger issue for the company than the actual credit losses is the terms of the senior convertible preferred. If the coupon is 10% if paid in cash, and 12% if they take the PIK option. That's $5B a year after tax and it wipes out all of the normalized profits of the enterprise. it's a far more egregious rate than any of the other pieces of paper the government bought in the midst of the crisis, and it was put there by the bush admin to prevent the GSE's from organically rebuilding their capital bases. [Again I agree – the object of the conservatorship terms were to wipe Fannie and Freddie out – the takeover was political in execution. However the current income of Fannie and Freddie is way above trend – and this will not be a problem if the high revenue is sustained.]

FRE preferreds trade at 1-3 cents on the dollar. they are basically warrants on the ability of the company to one day retire the government note. with a payoff function of 100x, i think it's a speculation worth taking. [They trade higher now – but I was buying at these prices.]

In summary – working through my models I will be wrong if

(a) the running income halves

(b) the end losses are higher than I thought and

On those I am most insecure on the running income as I discussed in Part V – but the running income is already running far faster than I anticipated when originally buying these securities.

The GSE takeover will wind up costing government surprisingly little. I think it will wind up being profitable. The future of the GSEs is not determined by their insolvency. That I think, time will take care of. It is determined by politics.

I will do a political series later – and they will have a wider audience. Wall Street wants to carve the GSE business up for the benefit of Goldman Sachs et al. The Wall Street political lobby is very effective and the terms of the GSE conservatorship prevent the GSEs from lobbying on their own behalf – which means that unless we are careful the Wall Street lobby will get what Wall Street wants. But that is for future political debate – and the Obama administration has sensibly put off decisions as to the GSE future until next year – and ideally they will put it off until even later.

I hope I have achieved what I wanted to with this series – which is to stop the model-free GSE bashing that had become the popular line of thought of the press and the blogosphere. Later I hope to take on the vested self interest behind that GSE bashing – showing them (especially the Mortgage Bankers Association) for the egregious self-interested participants that they are.

Betting on – or against – Obama hatred

2009-09-11T00:46:00.001+10:00

I run an investment business – and my blog is about investing. Sometimes (quite often) investing requires that you have a dispassionate look at politics, political trends and political decisions – even if those trends and decisions are anathema to you.

This is one of those times.

In March the US economy was in dire risk. Everyone who sold discretionary consumer products – especially high value discretionary consumer products – was watching their business implode about them. Well not everyone – but almost everyone.

One sector was having a rollicking boom – an off-the-scale big boom. It was recreational handguns.

A large number of Americans allowed themselves to be convinced that Obama was going to take their guns away. Or maybe they were convinced that socialists were taking over the country and that you needed to protect yourself. They may have even been convinced that Nazis were taking over the company (evidenced by eugenics policies under the Trojan horse of nationalised health care). Whatever… they bought guns. Lots of them. Here is a presentation from the Ruger AGM…

(Some corrections – the sales are probably on first quarter 2009 running at about 1.5 billion at the moment… this boom is MUCH bigger than show in in this graph).

I do not need to tell you a billion dollars (the current projected 2009 sales) represents a lot of handguns. Its up ~~250 percent~~ [see correction – but about 400 percent] since 2003. Very few consumer products (that are not made by Apple) can claim that.

The Obama-hatred inspired boom in handguns was so large that manufacturers simply could not keep up and handguns had to be obtained on order. The companies had exploding forward order books. As Smith Wesson said in a press release dated 22 June…

Our firearms backlog continued to increase dramatically during the quarter, and reached its peak at $268 million dollars by the end of April. That level is $218 million dollars higher than the same quarter one year ago.

More generally, Smith & Wesson deserves special mention. They have taken as their marketing guide the success of Harley Davidson – a company producing marginally inferior (but iconic) products and turned it into a mass-market product for wanting to rebel (and recapture youth) middle-aged baby boomers. What is more they have done so with some success – as evidenced by their shoot-the-lights-out record sales this quarter.

Dispassionately if you thought Obama hatred of the most extreme ilk was going to continue to grow like topsy you would buy Smith and Wesson and its ilk – and become a gun seller. As a committed Liberal I might not like the second amendment and I might like the second amendment supporters even less – but – we owe a duty to our clients to make money – and we might even do it owning the shares of a gun manufacturer.

Fortunately though that is not the decision we have taken. I am not sure I would be comfortable being a gun seller – and some of my clients might also have strong views. We prefer to short this…

The proof of Obama is there to see. Obama is (despite the protestations of Rush Limbaugh and his ilk) turning out to be a middle-of-the-road centrist. [Strong Liberals wanted change they could believe in… Smith & Wesson just wanted to sell guns.]

And they have. Smith and Wesson sales were good but their forward order book took a dive. To quote Wednesday’s press release

Our firearms backlog was $177.5 million at the end of the first quarter. Cancellations reduced backlog by approximately 10% during the quarter. It is important to note that our backlog always represents product that has been ordered but not yet shipped. As a result, it is possible that portions of the backlog could be cancelled if demand should suddenly drop.

The warning about the backlog not being binding is new – and it is clear from the new disclosure that they are having massive problems during this quarter with order cancellation.

The backlog dropped from $268 million to $178 million – a drop of 90 million. Ten percent of that (say $27 million) was order cancellation – but a net $63 million of sales came from the backlog. Total sales were 102 million – and less than 100 million in firearms. The rate at which Americans are placing orders for new Smith and Wesson handguns is collapsing.

The company did not tell us the current forward order book. At that rate of collapse what they are facing is a disaster.

Whether that says anything about the size and intensity of belief of the Rush Limbaugh right – well I will leave that for my readers to discern. We just want to make money for our clients – so we are short Smith & Wesson.

Modelling Fannie Mae and Freddie Mac - Part IX

2009-09-07T21:27:00.001+10:00

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…

2009-08-31T07:33:00.001+10:00

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…

2009-08-26T23:11:00.001+10:00

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

2009-08-25T17:10:00.001+10:00

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

2009-08-21T07:14:00.001+10:00

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.

Health Care Reform and single payer – an Australian perspective

2009-08-20T14:03:00.001+10:00

I write a financial blog which is republished on the largely political Talking Points Memo. I thought I better write something for both my audiences sometime – so I am jotting down my thoughts – from an Australian perspective – on single-payer health care reform. After all the ongoing Fannie and Freddie series has a limited audience.

Warning – I am putting the positives of the Australian system up front. There are some very substantial losers too – those are discussed at the end of the post.

Much of what I write is a 12 year old perspective (and the data I have in my head is that age) because 12 years ago I worked at the Australian Treasury and followed the numbers more closely. Moreover I am normally a bank analyst – and am stepping (way) out of my area of expertise. There are bound to be some errors and the lack of (recent) quantification I would not normally tolerate. With that caveat – here goes.

Australia has a hybrid private-socialised medical system.

For reference I think the Australian system is superior to anything in Canada or the USA. I am less familiar with the European models. The Australian system is better thought through and will work better than anything Obama is proposing. However Australia had weaker incumbents than America, some advantages over America (which I will get to) and has had 20 years tweaking the system in lots of ways to make it work better. These systems require a lot of tweaking and if Obama implements something worthwhile the next twenty years will be spent reforming it.

The way I think about it is that the US has a fundamentally broken market system. We know it is fundamentally broken because it costs a lot and produces fairly poor outcomes in aggregate. Stories about failure of insurance companies to honour their promises are legion. Many people have conditions that make them uninsurable. America spends a greater proportion of GDP on health (and greater dollars) for worse outcomes almost no matter how you measure it. If you do not agree with that statement you simply refuse to acknowledge clear facts on the ground. Health coverage is one of the major issues for middle America and many are unsatisfied. By contrast political and general population satisfaction with the Australian system is high and has by-and-large been rising.

Australia has a system whereby primary medical care (general practice doctors), much specialist health care (for example a cardiologist) and almost all important pharmaceuticals are covered by the government but with a copayment by patient. Most the copayments are large enough to be annoying (the service is not free) but do not cover anything like the costs. The copayments differ sometimes due to your income status. For instance most people have a copayment for pharmaceuticals of about $20 – but for (low income) pensioners the copayment is $5.

There are also government run public hospitals – run by State Governments – but where the funding almost entirely ultimately comes from the Federal Government through transfer payments to the States. These hospitals have a public emergency room which rations via triage. [Turn up with a sprained ankle and you might wait twelve hours, turn up with chest pains and the waters part for you.]

After admission to the public hospital [either through a consulting specialist or through the emergency room] you will get a shared ward and no doctor of your own choice – but a very high standard of care by global standards. Non-urgent procedures are queue rationed – and the queue is long and annoying and was once the main issue at State Elections. But the treatments eventually happen. Queue rationed conditions can involve some pain and hence there is real annoyance at the queues. [Gall stone removal for instance is queue rationed. They are painful until removed.]

You can be admitted to a private hospital in the same way as the public hospital. The admission is either from a consulting specialist or through the emergency room at the public hospital. At a private hospital you have your choice of doctor, often a private room, sometimes slightly better food and distinctly less pressure to leave until you are recuperated. Most importantly, private hospitals are not highly queue rationed. When my wife needed knee surgery after a skiing accident the wait was two weeks at a public hospital or alternatively the next day the doctor was in surgery at the private hospital. That was an easy choice.

To go to a private hospital you will either need to pay for it or have private health insurance. Most people do it with private health insurance with a moderately large copayment. [It costs me $800 to go to a private hospital – as a one-off payment – and there might be additional copayments for particular doctor treatment in the hospital. Nonetheless I would get out of something dire like open-heart surgery for a couple of thousand dollars. And I would get a nice room to recuperate in… The cost to me of open heart surgery and a knee reconstruction in a private hospital to me are about the same – the various excesses on private insurance.]

Many people with private health insurance choose to be treated in public hospitals because the service is better in the public hospital. For instance I know of the husband of a medical specialists who chose to have his open heart surgery in a public hospital because the hospital had an excellent reputation (and they knew and trusted the surgeon they were getting). They chose however to recuperate largely in the comfort of the (attached) private hospital. Many people also buy private health insurance because of the tax-driven requirement to do so – but chose to get treated in the public hospital because the copayments are (much) lower.

Ostensibly all of this was paid for through a “medicare surcharge” on your tax – about 1.5 percent. If the medicare surcharge was going to cover it the tax would have had to be about 8 percent (or about 6 percent of GDP). Many Australians (though far fewer now) did not know that the medicare surcharge did not fund public provision.

Private health insurance was originally and remains almost entirely community rated. That means that a private health insurance company charges the same amount to a 31 year old as a 75 year old. Moreover there is (and remains) almost no exclusion for pre-existing conditions. (The exclusion for pre-existing conditions usually just applies a waiting period – including some which are prohibitive such as an exclusion longer than nine months for pregnancy.)

Anyway community rating and lack of exclusions meant that private health insurance became the province of the elderly and the ill – and eventually became basically untenable because no healthy people ever took private health insurance. To keep the cost of private health insurance down private hospitals wound up getting subsidized – but even that did not work well.

Eventually the obvious solution was adopted – which was that if you earn more than $50 thousand per year your medicare surcharge rises by 1.5 percent if you do not have private medical insurance. This means that the young and wealthy take private health insurance even if they not think they have a reasonable probability of using it. The private health insurance business again became viable. The legal inability of private health insurance to exclude pre-existing conditions means that the private health insurers do not spend money denying claims on the basis of pre-existing conditions. Legal and claims denial cost is more than 10 percent of costs in America – so that is saved. The resurrection of private insurance (and hence private hospitals) has meant that queue rationing in public hospitals is reduced. That has meant that “hospital waiting lists” are much less of an issue at State elections than they were a decade ago.

The community rating of health insurance has also changed in one more important way – which is that it used not to be age-rated – and it is still not age rated provided you took out private health insurance before you were 30 and you maintain it continuously. If you took it out for the first time at 35 you will pay a “five year surcharge” for the rest of your life.

There are thus strong incentives for the well to do and the young to buy community rated health insurance. Insurance companies are not allowed to price discriminate in favour of the young – but they do advertise in favour of the young. Health insurance adverts are targeted entirely at the young (with pictures of 25 year-olds with health insurance) – and believe it or not trying to match health insurance brands with ipods.

There are plenty of things not covered by either medicare or private health insurance. These are known as extras. Extras include things like physiotherapy and dental – and they are exclusively marketed to the young. Whilst the health insurance company is prohibited from bundling their marketing looks bundled. Also there are things like “sign up for extras and get an ipod”.

There have been plenty of tweaks around the edges over the years. For example the elderly on low incomes (who qualified for a full government pension) and a few other selected elderly (veterans, war widows mainly) were entitled to the primary health care and pharmaceuticals without any copayment. There arose a small number of (mostly) elderly women whose idea of a social life was to visit a different doctor and a different pharmacist each day to have a chat (and get a script and have it filled). These small numbers of women imposed enormous costs on the medical system and a very small copayment ($2) produced a very large saving. When the copayment was raised to $5 there was no correspondingly large saving. Just the $2 mattered, and it mattered a surprising amount.

Also – even with very low cost medicine there are some things that are still not delivered even though it they clearly represent cost-effective medicine. The best example is pap smears. Very few women would go to the doctor for a pap smear for a social activity. They do however represent very cost-effective medicine. Getting young women to take jabs (the new HPV vaccine) also requires a solid advertising campaign.

Also some drugs pose particular issues. Viagra for instance is not delivered at subsidy through the health care system (for obvious reasons). But you can get subsidized Viagra if you have certain medical conditions (paraplegia being the important one). I kid you not that there have been minor problems with paraplegics dealing in Viagra.

Still – on most measures – the Australian system is a resounding success. The cost (proportion of GDP, dollars) is about half the USA – but the outcomes are better across the board. And that is not diet or lifestyle related. Australians are almost as fat as Americans.

Surprisingly the outcomes are as good or better for the rich too. The only exception is Australia’s chronically disadvantaged native (aboriginal) population.

Political acceptance is very high. The conservatives have (totally) made their peace with the system as proposing to remove it is electoral suicide. The support of the populace is almost total.

A major American hedge fund that once tried to employ me included in their pitch their (superior) access to medical care (as they are big donors to medical charities). To an Australian that sounded odd. Nobody would advertise a job (any job) or a business relationship with access to health care. It is just assumed to be OK. The idea of going to the USA for a medical procedure is also absurd (except for revolutionary new procedures done only by say two doctors in the world). And it is just as likely that an American will come here for such procedures. We simply do not carry an inferiority complex with respect to our medical care.

Bluntly the system works in almost every sense that matters.

From an investment and policy perspective the more interesting question why does it work so well and how can you learn from that? I am NOT going to assert that socialist provision of services works well in general – indeed if you believe it does then you are also failing to observe facts on the ground.

I do not have the numbers at hand – but I have a fair idea of this.

There are basically two ways Australia gets much better outcomes per dollar than America. They are the unimportant (but nice) one and the important one. Given Australia produces better health outcomes at spending maybe 7% of GDP less this is a very substantial economic issue. Translated to America those savings would be about a trillion dollars per annum. [Observation: getting this more-or-less right would be one of the most important things any government would ever do…]

The unimportant (but nice) way of getting lower health care costs in Australia

The advocates of the Australian system will note that lots of primary medical care is very cost effective. For instance pap smears stop cervical cancer. Cholesterol testing might lead to better lifestyles.

The primary health care is cheap compared to the cancers and the heart conditions. If you do better primary health care you can save money in aggregate.

I believe this – and it is important from a social perspective – but I remember chatting to the Treasury health care guys (a decade ago) and they thought that this was (at best) about 1 percent of the (then about) 7 percent cost advantage Australia had. [It may be very important though in the outcome advantage…]

The important way of getting lower health care costs in Australia

By contrast the main way getting lower health care costs in Australia is to squeeze the suppliers using government controlled and often government monopoly buying.

A very large part of the difference – the biggest single part when the Treasury guys took it apart – was that doctors were paid less in Australia. Doctors (not specialists) are middle income in Australia now – earning about 1.5 times average earnings. Thirty years ago doctors earnings were maybe 5 times average. The medical schools are now majority female reflecting in part the career aspirations of women versus men. General practice for instance can be performed part time (whilst the kids are school) and is thus a common women’s career. In regional areas Australia clearly does not pay doctors enough. Australia often imports doctors to work in remote areas and lack of doctors is a problem in aboriginal communities, mining towns and drier inland centres. Queue rationing is particularly bad in places that are less attractive to live. [As I live at the beach and have private health insurance queue rationing is not an issue for me – but it is a pivotal issue in many areas.]

Suppliers in general get squeezed. For instance the Australian government pays considerably less for most pharmaceuticals than is charged in the US. Margins in lots of research driven pharmaceutical would be squeezed. Badly.

Its not all bad though. Universal coverage means that volumes go up. A drug company may sell at a thinner margin – but the volume can offset this. In most prescription drugs the incremental costs are only about 10 percent – gross margins are 90 percent. Volume matters for profitability.

Reasons the US will never do this as well as Australia

The outcomes in Australia are surprisingly good – but they depend at least in part on the fact that Australia is small. Australia can shave margins for research driven medical products to very low levels because the research is not funded from Australia. If the US were to push margins too low they would crimp medical research.

I have no quantification of how important this is but if had to guess it would be ~~at least~~ about 1 percent of GDP or a seventh of the the entire savings. ~~It may well be 2 percent. In the US context that is $150 to 300 billion per annum.~~ If anyone has a quantification could they please share it. [Modification due to someone making an entirely sensible comment on my blog…]

The second reason that America will not do this quite as well is the power of the American vested interests – and those vested interests have a lot to lose because the main way lower costs are achieved is by squeezing those interests.

Winners and losers

For medical industries there are two effects going in opposite directions.

1). The government – being a monopoly buyer – squeezes margins, and

2). Universal coverage expands usage.

It is entirely possible that something will be a big winner or loser – but the savings as a percent of GDP means that the losers will be significantly more prevalent. As a rule this is atrocious for investment in medical related businesses. The Bronte Capital blog was founded as an investment blog. So I should state that negative up front. However this saving – and it is a huge saving – is transferred in part to other businesses – and hence is not bad for investments in most the rest of the US economy. If you are a manufacturer with huge health costs in America this would be a great boon.

By contrast if you are part of the medico and medico-legal establishment then any decent semi-socialised medical system is long term poison for you. It has proven to be long term poison for doctors’ incomes in Australia. Dentists – where socialisation has not taken root – earn considerably more than doctors these days.

PS. The first comment on this post nailed one other major difference between Australia and the United States. Australia has a much less expensive tort regime. Insurance premiums are MUCH cheaper for Australian doctors and that benefit is passed on to patients.

PPS. I would like to thank Yves Smith of Naked Capitalism for the link and comments. Yves has lived in both NYC and Sydney and concurs with my article. However Yves experience of the Australian system would have been biased (upwards) in the same matter as mine as she too lived in a place which was attractive to live and she too would have had the income to queue jump had something required hospital treatment. John Barrdear’s comments are also accurate.

Modelling Fannie Mae and Freddie Mac – Part VI

2009-08-19T08:33:00.001+10:00

This is the money post. I put Parts I, II, III, IV and V together to come to the surprising conclusion that both Fannie and Freddie survive. This conclusion is highly-non-consensus and has substantial political and investment implications. Also I would like to thank FTAlphaville for linking to this series – most the rest of the blogosphere has been silent possibly because I disagree with their preconceptions/ideology. The comments on FTAlphaville reflect mainstream finance opinion – that Fannie and Freddie are irredeemably insolvent.

Putting the model together

We now have enough to do some basic modelling of Fannie Mae and Freddie Mac. I will do it for Freddie Mac only – and leave it to the more ambitious readers to do it for Fannie Mae.*

In the second post in this series I demonstrated how the losses that have been booked to date (rather than provisioned to date) have come primarily from outside the traditional guarantee book of business. Those losses are primarily mark-to-market losses on mortgage securities (especially subprime securities), mark to market losses on the hedge book and the write-off of tax assets.

None of those loss categories are going to expand – and indeed some will reverse.

In the fourth post I estimated the losses in the traditional guarantee book of business. I have asserted that the model is fairly robust (and will cover that in the next three posts) however I showed under quite reasonable assumption that there were $37.6 billion in losses to be realised at Freddie Mac at year end 2008. Since then $2.9 billion have been realised so there are $34.7 billion left to come.

Of these losses 25.2 billion have already been provided for. From now until when the problem-years of business loans run off Freddie will only need to take another 12.5 billion in provisions. They may elect to take more than $12.5 billion in provisions – but if they do and my models are reasonable – then in all likelihood the excess provisions will be reversed through the income statement.

Now if you go to the last Freddie Mac results you will see they have a positive net worth of $8.2 billion. However they owe the government $51.7 billion, as the government has injected $51.7 billion in senior preferred securities. They are thus $43.5 billion in the hole.

They will also – over time – take another $12.5 billion in provisions. So now, until all the problem years of business have run off, they will be $56 billion in capital short.

The Government can get its money back on their “investment” in Freddie Mac provided Freddie can earn more than $56 billion over a reasonable time period and meet the government interest charges.

This would be more certain if some of the losses described in Part II reversed. I am pretty sure that they will – but lets ignore them (until a later post). Pre-tax, pre-provision operating profits of Freddie Mac are running at over $15 billion. If the government were not demanding 10 percent on its preference shares the companies would be sufficiently well capitalised to repay their interest in 4 years. With the drag of having to pay the government $5 billion per annum it will take a bit over five years. Either way the operating profits of Freddie Mac are big enough to ensure the government gets its money back. If you do the same analysis for Fannie Mae its is even better. However Fannie has less aggressively marked private label securities to market so it has less chance of recoveries from their current marks. The consensus view that the GSEs are forever toast – and forever a drain on the US Government is very likely wrong.

Implications

I have tried modelling this half a dozen ways and the result is fairly robust. If anything the GSEs (especially Freddie) are solvent quicker than the model I have presented suggests. Indeed if the tax losses are allowed to be bought back as capital they will reach solvency a year and a half earlier – and will be in the position to repay substantial government money during 2012.

The losses (even after all losses are booked) come from primarily outside the traditional business of guaranteeing small well-secured and documented mortgages.

Traditional GSE business (guaranteeing lower value mortgages with reasonable terms on full documentation and with a down-payment) was very effective at raising home-ownership rates whereas modern subprime lending, it seems, just caused a blip in home-ownership rates that corrected with much pain. Later in this series I am going to go through the politics of this issue. However for now it suffices to say that by the time Obama is up for re-election the Government will be in a position to ask for and receive considerable repayment from the GSEs. One of the festering sores from this crisis will appear healed.

One more implication for my investor readers (and this after all started as an investment blog). If the GSEs can repay their debt to the government – and I think that they can – then the common stock in both companies has value. That is a non-consensus view. However the real value is in the preferred securities.

The preferred securities are currently trading between 4 and 6 cents on the dollar (and went down whilst I was writing this sequence indicating my readers either do not believe me, do not have money or had no idea where I was going).

The preference shares are all non-cumulative so you are not entitled to back-coupons when they resume paying – but they will resume paying sometime in the next 4-7 years. At 4-6 cents in the dollar that makes them a real bargain – offering 16 to 25 times your money over 4-7 years. That is a better return than you will get in most places. Even the lower end of the range offers a 50 percent annualised return. The return on the preference shares is substantially better than any possible return on the common stock. However – and it should be noted – the conservatorship agreement gives no time period and specifies no criteria for the government to release Fannie and Freddie for conservatorship. This means that even if this model is right – and Fannie and Freddie do recapitalise internally – there is still no guarantee you will get paid on the preferred. Political risk is omnipresent.

Bronte’s position

At Bronte we have thought that the pre-tax, pre-provision profits were sufficient to recapitalise the GSEs for a while. We purchased large holdings of these securities below 2 cents in the dollar. Eventually the preferreds started rising leading to some financial-press scepticism that they would ever be worth anything. All I can say – at Bronte our money and our client money is where our mouth is.

There are plenty of risks to this rosy hypothesis. These fall mainly into the political risk camp (there are many people who will fight a resurrection of the GSEs). However there is model and economic risk as well. I will examine the risks (model, economic and political) in later posts. The next three posts are (unfortunately) a little disjointed because all I am trying to do is subject my model to different data-tests and see if it is robust. You will find that I am much more comfortable about the credit loss estimates in the model (Part IV) than I am about the income estimate (Part V).

What makes me most uncomfortable though is the political risks – and those I have very little idea how to analyse. Late in this series I will be very keen to see if I can get a robust discussion at Talking Points Memo – because those readers know far more about politics than me or most the regular commentators on my blog. For the moment though what we have is Republicans (and a much smaller number of Democrats) who are extremely keen to put Fannie and Freddie into liquidation now and hence make all of this modelling entirely redundant.

John

*At Bronte we have done the models for both Fannie Mae and Freddie Mac. If the relevant Treasury or NEC officials wish to contact me we will provide our models more generally.

Modelling Fannie Mae and Freddie Mac – Part V

2009-08-18T03:13:00.002+10:00

In Parts I to IV of this sequence I explained where the losses already realised at Fannie Mae and Freddie Mac came from – and where future losses might come from. I showed that the companies have almost reached reserve adequacy – a conclusion diametrically opposed to the consensus view that these companies are hopelessly insolvent even to the point that they threaten US government solvency. On losses the consensus appears to be simply wrong.

In this post I show how the revenue of the GSEs is up very sharply.

No competition

As far as Fannie and Freddie are concerned, the best thing about the mortgage crisis is that these institutions are now the whole market. The private sector market in US mortgages has almost entirely disappeared. They are even allowed now to do jumbo mortgages.

Lack of competition means fat margins – and just as the revenue at Bank of America rose sharply during the crisis so does the revenue at the GSEs.

Here is the quarterly sequence of net interest income for Freddie Mac. The numbers for Fannie are similar…

Quarter	Net interest margin ($ millions)
2007 Q4	774
2008 Q1	798
2008 Q2	1529
2008 Q3	1844
2008 Q4	2625
2009 Q1	3859
2009 Q2	4255

The growth in these numbers is breathtaking. Operating costs are roughly flat. You would think they are rising because foreclosure and credit management (which costs Freddie money). However I suspect that those costs are offset by lower bonus payments to staff and similar costs.

But with flat costs and revenue rising like this Fannie and Freddie are much more profitable on a pre-tax, pre-provision basis.

Not all of this growth in profit is sustainable. A bit is reversal of previously booked losses on derivative hedging instruments. (I explained this reversal in Part II and the explanation is technical – I do not feel the need to repeat the explanation here.)

Further Freddie Mac in particular has been an astoundingly good judge of when to hedge out duration risk. I wrote a post a while back about just how good Freddie’s trading has been. The seemingly superior interest rate risk management at Freddie has continued – though I would not bank on profits from that being permanent.

That said – the pre-tax, pre-provision profits at Freddie are probably going to run about $15 billion per year for a while. Much of that increase will be long-lasting as private sector competition in the mortgage market is not going to return rapidly – and so margins should remain fat. That $15 billion per year can offset an awful lot of losses.

What it means for the future of Freddie and Fannie is the subject of the next post.

Modelling Fannie Mae and Freddie Mac – Part IV

2009-08-15T14:27:00.002+10:00

This blog is reprinted on Talking Point Memo. In that format the post is unreadable unless you click the permalink. The tables are too wide – and have prompted a reformat of my home blog.

In the last post I introduced readers to cumulative default curves. In this post I am going to create a naïve (but surprisingly robust) model of end losses using those cumulative default curves. Later posts are going to detail the limitations of this model and what (if anything) allows me to attest to the model’s accuracy...

Also I am going to use only the cumulative default curves up until December 2008. There are a couple of reasons for doing this. Firstly I am lazy and at Bronte Capital we originally did this analysis in March and I can cut and paste the internal note we wrote at our fund. More pertinently though the default curve past December gets distorted by the foreclosure moratorium which meant that some individual cumulative default curves are quite kinked. For instance the sequential default for the last four quarters on the Fannie Mae 2007 vintage is 1.1 billion, 1.5 billion, 1.0 billion and 1.5 billion. If you used the 1.0 billion default recorded in the first quarter of this year you would underestimate the end defaults by presuming the foreclosure moratorium was a continuing part of the sequence and not a distorted data-point. So whilst it appears lazy to use analysis I wrote in March not updated for new results, there is some method in that.

Here is the default curve – as published by Freddie Mac – until the end of 2008. This curve does not include the kinks caused by foreclosure moratoriums.

It has the usual “to the sky” character for the 2006 and 2007 books of business, however the kinks a the end of the curve are not present. (Compare to 2003 curve to the most recent 2003 curve which you can find in the last post – and which has a notable kink at the end of it.)

I would have loved the data points on this curve as actual numbers to run through the model. I wrote to Freddie Mac (and to Fannie Mae) and asked for that data and they refused to give it to me. So I did the best I could and printed the curves on graph paper and read the numbers off the graph paper. [If you are a policy analyst at the National Economic Council looking at this issue perhaps the company will give you actual data points!]

The last six quarters of the 2006 pool for Freddie had cumulative defaults in the following table. I have also included the cumulative defaults of the 2000 series as a comparison – and the ratio to the 2000 vintage as follows:

Last six data points	cumulative default 2006 originations (bps)	cumulative default 2000 originations (bps)	Ratio of cumulative defaults 2006/2000
Y3, q4	115	41	2.8
Y3, q3	90	35	2.6
Y3, q2	64	29	2.2
Y3, q1	42	22	1.9
Y3, q4	24	15	1.6
Y2, q3	13	8	1.6

If the ratio were constant (it is not) then we would have a really good method of projection. Instead the 2006 pool is getting worse relative to the 2000 pool quarter by quarter. My guess is that the end cumulative defaults will not be 2.8 times the 2000 pool (the current ratio) but 4.5 times (substantially worse than the current ratio). This is an educated guess looking at the charts – nothing else. I have tried testing this guess with (former) senior finance execs at Fannie. They said they would like to measure they rate at which the curves are diverging (preferably by state or market character) against rates at which house prices are falling. They want to test how much of the expansion of defaults is induced by falling house prices. They are after a sounder end-default estimate.

That said – I am stuck with the educated guess made above.

We can make a similar educated guess for other years of origination. Here it is:

	Current cumulative default (bps)	Guessed end default ratio	End cumulative default
Base year 2000	104		110
2001	74	0.8	88
2002	62	0.75	83
2003	32	0.7	77
2004	52	1.1	121
2005	81	2.5	275
2006	115	4.5	495
2007	63	6	660
2008	negligible		400

Obviously the big problem years are the 2005, 06, 07 and 08. Previous years have largely played out. That is to be expected because if you had a mortgage you couldn’t afford originated in 2004 then you either refinanced it in the boom into a later year or you have defaulted already. I have only guessed the end default in 2008 – there is simply not enough public data to make anything other than an informed guess – however gossip suggests that 2008 is a bad year but not as bad as 06 or 07 for defaults.

From here – with data about how many mortgages were originated each year – you should be able to work out how many defaults are yet to occur. This is done below. The originations for the years 2000-2003 are made up because I can’t find the data any more – but the action is not there anyway. What matters is the later year.

Year

current cumulative default (bps)

end cumulative default (bps)

Defaults still to come (bps)

Originations in year (billions)

Defaults still to come (billions)

2000

104

110

450

0.3

2001

450

0.6

2002

450

0.9

2003

450

2.0

2004

121

495

3.4

2005

275

194

501

9.7

2006

115

495

380

577

21.9

2007

660

597

460

27.5

2008

400

358

14.3

Total defaults still to come

80.7

This suggests that there are almost 81 billion of mortgages in the book yet to default. This is considerably more than the cumulative defaults to date – and implies a massive increase in defaults. Whitney Tilson is right – prime mortgages owned by the GSEs are going to default in a massive way in the next couple of years.

I have done a similar analysis for Fannie Mae and I predicted that just over $125 billion of defaults were embedded in the default curves at that company.

Remember though that these are defaults, not losses. Severity is the key to the losses.

Neither company publishes severity by year of origination (something I would deeply desire). However Fannie Mae publishes its severity in each period for the whole book.

The severity at Fannie Mae was as low as 9% in 2005. I do not have an accurate table of severity by year of origination – but Fannie gives recovery data as follows (severity percentage = 1 minus recovery percentage):

Real estate owned net sales compared with unpaid principal balances (which is one minus severity numbers)

2005

93%

2006

89%

2007

77%

2008 q1

74%

2008 q2

74%

2008 q3

70%

2008 q4

61%

2009 q1

57%

2009 q2

54%

The severity numbers at Freddie Mac are consistently a little lower than at Fannie Mae. I think the reason is that Fannie Mae did most of Countrywide’s business and there was more valuation fraud at Countrywide. If this is the case it strikes me that Fannie has a good case against Bank of America (who now own Countrywide) but they have not chosen to litigate.

Either way, severity is rising though with the recent stabilisation of REO sales prices (more evident at Freddie than Fannie) I think we can presume some stabilisation at the new (higher) severity levels. Anyway I ran the model assuming end average severities for various books of business. This produces an estimate of losses yet to come.

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

When I originally wrote this model Freddie Mac had already provided for 15.6 billion losses yet to come. That is the provisions number at the end of 2008 in the following graph.

Given that I thought that there was $37.6 billion of losses embedded in the book I thought that Freddie was under-reserved by $22 billion. This is a big number to be sure – but in the scheme of things that are said about the losses at Fannie Mae and Freddie Mac most people (certainly most taxpayers) would be happy that the hole in Freddie Mac’s book is “only” $22 billion. [The level of under-provisioning at Fannie Mae was similar… our estimate was that neither institution posed much threat to the US Treasury.]

Since I did this estimate Freddie Mac has actually realised $2.9 billion of losses and the reserves have risen to 25.2 billion. This means that Freddie has now provided for an additional 12.5 billion dollars. The remaining hole in Freddie’s accounts is now “small” – say 7.5 billion dollars.

Plausibility check

When you estimate something in such a convoluted way it is incumbent to run a plausibility check. Look again at the losses and reserve picture for Freddie Mac.

Note that Freddie is writing off roughly 900 million per until the last quarter. The spike in the last quarter to 1.9 billion was due to the expiry of the foreclosure moratorium as well as due to the generally bad housing market. I estimated that at the end of 2008 there were 37 billion in losses left to come. Since then they have realised $2.9 billion in losses including the spike in realised losses at the end of the foreclosure moratorium. I think there are now about 34 billion in losses left to come. If the next six months is twice as bad as the last six months then we will be running off at roughly $6 billion per half or $12 billion per annum. We can cope with three years that bad without threatening my estimate. Given that the early stage delinquency of the GSEs is currently falling (see this OTC report) I think this is a reasonable (if harsh) assumption.

Plausibility summary: my loss estimates pass this plausibility check. I have run half a dozen other plausibility checks (some quite convoluted and detailed). The estimates are robust to all of them.

Summary of Part IV

In this post I show how using naïve (but surprisingly robust) models using data in the cumulative default curves you can get estimates of the end losses of both Fannie and Freddie.

Using these models I show that the end losses in the traditional guarantee book of business are very close to the reserves currently embedded in Freddie Mac’s accounts. [The same applies at Fannie Mae too.]

This argues strongly against the notion that Fannie Mae and Freddie Mac will be substantial ongoing drains on the Federal budget. It also argues fairly strongly against the notion that the quasi-government GSEs cost taxpayers more than the private sector companies that they competed with. AIG – who led the FM Watch – an anti-Fannie-and-Freddie lobby group will wind up costing taxpayers considerably more than the GSEs.

Moreover the losses on the GSE’s core business (the losses modelled in this post) look like they are about the same as the original GSE capital base. If the GSEs had not (foolishly) purchased private label mortgage securities (the losses detailed in Part II) then the cost to the taxpayer would have been negligible.

This has big implications for the reform of GSEs – something supposedly under discussion at the NEC – and also of concern to many. The traditional guarantee business of the GSEs simply did not perform that badly during the worst mortgage crisis in modern finance. That should be borne in mind by the GSE critics.

As to what the end cost to the government will be – and whether there is any residual value in the remaining Fannie and Freddie securities – that is the subject of a future post in this sequence.

Mr Big Wells and the new faster SEC

2009-08-14T11:55:00.001+10:00

I just received and filled out a customer satisfaction survey from the Securities Exchange Commission. Its prompted me to take some time off from the mega-Fannie-and-Freddie series. I wasn’t satisfied – and the questions did not allow me to spell out all the ways that I was dissatisfied – so I will do it here. Especially as the SEC is promising to be more responsive – and quicker.

The Bronte Experience

On the evidence presented I beg to differ about quicker.

Sometimes something so easy to prosecute and so charmingly banal comes across my desk that I wonder if there is any future in securities regulation in the US.

I point to a small but well promoted penny stock. The name is Cobra Oil and Gas.

This stock was pitched (by email) to Bronte Capital by a promoter who I had never heard of. [I have been around a while – and a broker/promoter that I have not heard of makes me pause for thought…]

Cobra – according to the pitch – has some very large shale-oil reserves in the lower 48.

That alone makes it worth 15 minutes of my time. And that is all it took…

Cobra claims that it has secured the services (as a consultant) of Dr Dualat Mamora – a renowned professor in petroleum engineering.

Cobra Oil & Gas Company is pleased to announce that the company, along with its partner Enercor Inc., has secured the use of a proprietary oil extraction process for its Utah Oil Sands Prospect. The process, known as In-situ Combustion ('ISC'), will be overseen and carried out by Vernal, Utah-based Rocky Mountain Consulting, utilizing the expertise of renowned petroleum engineer Dr. Daulat Mamora, who is an expert in ISC methodology.

This was easy to check. I emailed Dr Mamora and received the following reply:

Mr. Hempton:

I have never heard of Cobra Oil & Gas Company, nor am I consulting for this company. I conduct insitu combustion research and publish in this area. I guess it is just too easy to "google" and obtain a persons' name whose expertise is in insitu combustion.

Thank you for pointing the article out to me. I am going to write to the company requesting them to remove my name from the article and from all future communications from the company.

I sent all this to the local head of enforcement at the SEC. Receipt was acknowledged.

Anyway claiming you have a consultant who is not your consultant is probably just a little trivial. But then I am not sure it is just the consultant who is falsified. The CEO of the company is Mr. Massimiliano (Max) Pozzoni. Now my Italian is not very strong – but even I can see that this name translates roughly as Mr Big Wells – a name that is entirely appropriate for the CEO of a suspect oil and gas company. Max Pozzoni has a rather thin CV – consisting of executive positions at other pump-and-dump oil and gas stocks. My guess is that he does not exist – but he appears (at least in voice) in this video…

We have a CEO whose existence is suspect (and who has a funny name) and a consultant who has never heard of the company he is consulting for.

I can think of only one reason not to close this scam – which is that somehow you can find Mr Big Wells (whoever he might be) – and you are preserving it all for criminal action. But the right action is not a suspension (though the SEC should do that too). The right action is to suspend the stock, chase the seller of the big parcels and invite the Justice Department to press criminal charges. If the CEO cannot be found the company should be wound up.

For now however it seems that the new faster SEC will be too slow and the baddies will get away with the moolah…

That however is not the reason I am writing. Mr Big Wells is probably better described as a small dip-stick.

By contrast, I have thrown the SEC a very solid argument that a billion dollar plus New York Stock Exchange listed oil and gas company is largely fraudulent in its statements to the market. I know the relevant regional head of enforcement (the same regional head) is informed as to the issues. Unlike Cobra however this is a complex case – and I think I should give the SEC time to do its job before I go public.

After all, its a quicker more responsive SEC and I shouldn’t have to wait too long…