FHFA implies Freddie Mac will be profitable in 2011
Nov/104
On October 21st, FHFA released projections showing a range of possible additional draws from the U.S. Treasury required by Fannie Mae and Freddie Mac. The report was interesting because it included projections about the companies’ future revenues, expenses and net income. Although the projections are not detailed by income statement line item, they do imply that Freddie Mac will be profitable in 2011 and Fannie Mae will be profitable in 2013 in the base case scenario.
How do you conclude Freddie Mac will be profitable in 2011?
In the FHFA’s projections, the regulator shows a chart projecting future draws from the Treasury for each company. Here’s Freddie’s chart:
By focusing on the base scenario (or Scenario 2 in the chart), we can see that the FHFA projects Freddie Mac to require a $10 billion draw from the Treasury in the 2nd half of 2010, a $3 billion draw from the Treasury in 2011 and no draws in 2012 and beyond. The draws included payments made back to the Treasury for the Zombie Dividends* on the Treasury’s senior preferred stock, which has the usury rate of 10%. The draws from the Treasury are equivalent to Net Income Available to Common Shareholders.
“Net Income” is more useful than “Net Income Available to Common Shareholders” in determining whether Freddie Mac is a viable entity because it is not obscured by the Zombie Dividends paid to the Treasury. I reviewed the reasons why the Treasury should reduce the dividend rate on its GSE senior preferred stock in previous articles.
| 2H10 | 2011 | 2012 | 2013 | |
| Previous cumulative draw from Treasury | -63 | -73 | -76 | -76 |
| Net Income | -7 | 4 | 7 | 7 |
| Treasury Zombie Dividends | -3 | -7 | -7 | -7 |
| Net Income available to Common Shareholders (i.e., current draw from Treasury) | -10 | -3 | 0 | 0 |
| Cumulative draw from Treasury | -73 | -76 | -76 | -76 |
Using the similar information for Fannie Mae, the FHFA implies that Fannie will turn profitable in 2013.
How can you say Freddie Mac will be profitable but still require draws from the Treasury?
I am most focused on whether Freddie Mac can report profits before dividend payments to the Treasury. I view the net income line item of Freddie Mac as the best indicator of the profit earning capability of the corporate entity. I view the senior preferred stock issued to the Treasury as an expensive form of capital that can be restructured if the underlying company is profitable. For example, if Freddie restructured the Treasury’s stake in a similar manner to the AIG restructuring, the Treasury’s senior preferred would be converted in common stock and the Zombie Dividends would be eliminated.
What happens if the scenarios in the FHFA’s projections are too optimistic?
If anything, Freddie’s results might be better than the base case scenario of these projections because the assumptions behind these projections are conservative. Here are the possible areas of conservatism:
1) Zero growth in credit guaranty business – Although growth in this business has been negative single digits for the past year, this will not always be the case. With the housing market weak, mortgage debt outstanding has been falling. Plus, the FHA has recently raised prices, so I would expect for more market share for the GSEs in the short-term. The private-label mortgage securities is years away from becoming a competitor again. Growth in this business will resume with the continued recovery in the housing market.
2) No additional retained portfolio business – Although this business is mandated to shrink, I believe this assumption is more aggressive than the mandated decline in the mortgage portfolio. The portfolio is the main way the GSEs are generating revenue right now. These revenues are offsetting the losses in the credit business. I think it is foolish to shrink this business since the FHFA itself has said most of the losses came from the credit business.
3) No recognition of Deferred Tax Asset value – Based on the limited information in the projections, it does not appear as though the GSEs are given credit for a revaluation of their deferred tax-asset once they demonstrate a return to sustained profitability. Recognizing this asset will create capital in the near-term to allow an accelerated payback to the Treasury.
4) 5% drop in ABX and CMBX – This assumption has already proven false since we know these markets have been strong since the June 30, 2009 start of the projections.
5) Regulator has incentive to be conservative – Government projections have been consistently conservative coming out of the financial crisis. No one at the FHFA has any desire to raise expectations and have to reverse course down the road.
Conclusion
Fannie and Freddie are not endless black holes of losses. The total loss is becoming clear with passage of time. Eventually, the Treasury may get paid back for its capital investment into the companies. Profitable companies with poor capital structures lead to restructuring opportunities.
The point of this article is there a potential restructuring opportunity in Freddie Mac’s capital structure because the corporate entity will turn profitable in 2011. The potential reform of Freddie Mac and Fannie Mae will be near impossible as liberals want a full nationalization of the companies and conservatives want complete privatization. Neither scenario is pragmatic. The clearest path is to do no damage to the housing market and modify the current form of Fannie and Freddie. This is the path of least resistance politically and the least risky option economically.
Possible options for modifying Fannie and Freddie are to improve their business practices: 1) prohibit low doc and no doc lending, 2) prohibit investment in private label mortgage securities, and 3) give the FHFA authority over both housing goals and safety and soundness with a priority on safety and soundness.
Disclaimer – Please do not buy the common stock because you read this article. I believe the common stock does not have much upside because 1) the Treasury owns an 80% warrant on both companies, 2) there is a potential for additional dilution through a preferred for common swap to restructure the Treasury’s senior preferred stock, and 3) one or both of the GSEs could be put through receivership and wipe out common shareholders entirely.
* – Zombie Dividends – I call the dividend payments on the Treasury’s senior preferred stock Zombie Dividends because Treasury Secretary Paulson wanted the GSE’s dead at the time he put them into Conservatorship. He forced them to pay a 10% dividend rate to the Treasury on its senior preferred stock investment. No other financial institution has had to actually pay to the government a 10% rate like the GSEs have. The commercial banks pay a 5% rate on the TARP preferred stock. AIG initially had to pay a 10% rate, but it was restructured into a non-cumulative preferred stock and AIG Board of Directors has chosen not to pay the dividend since early 2009.
Disclosure – long Freddie Mac preferred stock and Fannie Mae preferred stock
ICBA Calls for Restoring GSE Preferred Dividends
Mar/100
Last week, Camden Fine, President and CEO of the Independent Community Bankers Association, sent a letter to Secretary of the Treasury Timothy Geithner asking Treasury to restore the dividends on Fannie Mae and Freddie Mac preferred stock. Reading the letter, the community bankers feel like they were sold a bill of goods by Hank Paulson. It seems that Paulson’s book has enraged the ICBA, especially the fact that Paulson was proud to keep his promise to his “Chinese friends” for making them whole on GSE senior debt and MBS.
Let me know if it feels like the political rhetoric has died down regarding the GSEs.
March 12, 2010
The Honorable Timothy Geithner
Secretary of the Treasury
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220
Dear Secretary Geithner:
On behalf of the 5,000 members of the Independent Community Bankers of America I urge prompt Treasury action to remedy the status of preferred shareholders of the Government Sponsored Enterprises Fannie Mae and Freddie Mac. As the Administration and Treasury continue to control Fannie Mae and Freddie Mac in conservatorship and seek resolution to this unique GSE status, it is imperative that community bank GSE preferred shareholders are made whole to bolster capital and lending levels in this challenging financial and economic environment.
The abrupt action by then Treasury Secretary Henry Paulson to seize Fannie and Freddie through conservatorship was unjustly done in a way that needlessly crushed the value of GSE preferred shares, injuring over a thousand community banks that purchased these shares as a safe AAArated investment at the encouragement of their bank regulators. Since banks received special regulatory capital treatment for them and since banks are generally prohibited from investing in stock of other corporations, Fannie and Freddie preferred stock were important investments with full regulatory blessing.
Shockingly, Secretary Paulson fully acknowledges in his new book On the Brink that this action constituted an “ambush.” It took place shortly after he and the GSE regulators issued statements that supported the ongoing viability and capital levels of the GSEs in their current form as “shareholder-owned companies,” in order to “calm the market fears of a government takeover that would wipe out shareholders.” Now there is no doubt the government’s action was indeed an unjustified “ambush” structured in a way that continues to have detrimental consequences on many community banks that relied on the guidance of Treasury and bank regulators and were intentionally deceived on their Fannie and Freddie preferred holdings.
Americans expect and demand much better from their government and leaders. The lCBA urges the Treasury to help restore the value of the Fannie and Freddie community bank preferred share holdings to levels prior to the abrupt conservatorship of Fannie and Freddie. Preferred Fannie and Freddie shareholders should be compensated for the government’s action of eliminating all dividend payments and placing the preferred shares in a second position.
Rather than help stabilize the financial sector and boost lending, this government “ambush” further hurt banks’ capital levels, weakened the banks and reduced available credit. Such rogue changing of the rules governing preferred stock contracts also sent the entire market for financial preferred shares into a freefall, making it even more difficult for financial firms to raise needed capital. Notably, nearly $36 billion in Fannie and Freddie preferred stock was outstanding prior to their conservatorship. An estimated $15 to $20 billion was held by the banking sector and almost one-third of banks reported holdings including many Main Street community banks.
The Troubled Asset Relief Fund devoted $700 billion to help restoring financial sector credit and to increase lending with mixed use and results to date. However, if we truly want to help stabilize the financial sector, boost small business credit and economic growth, Treasury must also restore a reasonable value to GSE preferred stock so that affected banks can again increase their lending.
ICBA urges immediately restoring the dividend payments on Fannie and Freddie preferred shares and paying injured holders the amount of suspended dividends from September 7, 2008 on an estimated $20 billion in GSE preferred holdings. As the Administration works to remove the GSEs from conservatorship ICBA urges it be done in a way that will restore a reasonable value to the preferred shares. Helping restore the $15 to $20 billion in community banks capital value crushed by the unwarranted Treasury actions perpetrated on preferred shares can foster $150 billion to $200 billion in new lending as banks can leverage this capital.
Sadly, the Treasury and policymakers were forewarned of the distress and fallout that lmnecessarilv crushing GSE preferred shares would cause. For example, the attached letter dated August 271h, 2008 specifically warned of the community banks’ significant GSE preferred holdings that typically pay a fixed dividend and take priority over common stock. Unfortunately, Treasury chose to ignore the warnings when they turned the GSE preferred stock upside down when placing Fannie and Freddie into conservatorship on September 7, 2008. Mr. Paulson acknowledges in his book that he ambushed Fannie and Freddie shareholders in part to help satisfy the Chinese government, which owned billions of dollars in Fannie and Freddie bonds. Mr. Paulson notes that he called “my old friend Zhou Xiaochuan,” the head of the Central Bank of China, and China’s key financial leaders and said: “I always said we’d live up to our obligations.” ICBA believes it is now time to live up to United States obligations and help spur lending by compensating Fannie and Freddie preferred shareholders for the unjust actions of the government.
Sincerely,
/s/
Camden R. Fine
President and CEO
cc: The Honorable David Axelrod, Assistant to the President and Senior Advisor
The Honorable Lawrence Summers, Assistant to the President for Economic Policy and
Director, National Economic Council
The Honorable Eric Holder, Jr., U.s. Attorney General
The Honorable Michael Barr, Assistant Secretary for Financial Institutions
The Honorable Herb Allison, Jr, Assistant Secretary for Financial Institutions
The Honorable Barney Frank, Chairman, House Financial Services Committee
The Honorable Spencer Bachus, Ranking Member House Financial Services Committee
The Honorable Chris Dodd, Chairman, Senate Committee on Banking
The Honorable Richard Shelby, Ranking Member, Senate Committee on Banking
Interesting GSE Article at Housing Wire
Mar/100
Paul Jackson, the publisher of HosuingWire magazine, wrote an interesting article about the lack of a political solution to the GSEs.
I find this article interesting because there is a growing realization that the path of least resistence for resolving the GSEs Conservatorship is to simply allow them to exit in their current form when they return to profitability.
GSE Critic Ed Pinto Has No Idea on GSE Loan Losses
Feb/101
There was a Fox Business news article criticizing the Obama Administration for lowering its loss estimate on the GSEs. Mr. Pinto has no factual basis behind his claim that the Obama Administration is just being “optimist” in lowering its projections of losses for Fannie and Freddie. He has no how well or poorly the credit losses of the GSEs are going to play out over the next few years. The critics of these companies continue to spread negative propaganda that the mainstream press is too happy to publish. The reality is the companies have built up massive loan loss reserves that they’ll never fully utilize. For example in the 3rd quarter of 2009, Freddie Mac provided for $7.6 billion of credit losses, but the company only charged off $2.3 billion of loans.
This over-reserving made Freddie’s net income statement look weaker than necessary. Freddie added $5.3 billion to its loan loss reserve in Q3. In its most recent quarter, Wells Fargo only added $0.5 billion to its loan loss reserve. Freddie would’ve reported a profit in Q3 had it not overly added to its loan loss reserve.
The over-reserving also hides Freddie’s balance sheet strength in the loan loss reserve, instead of the capital account. Freddie’s loan loss reserve now stands at 3.28x their run rate of net charge-offs. This compares to Well Fargo’s loan loss reserve which only stands at 1.16x charge-offs or JP Morgan Chase’s at 1.01x charge-offs.
This raises the question in my mind whether the regulator is forcing Freddie to over-reserve for loan losses to make the company look weaker than it really is. They may be doing this to hide the fact that the company should not have been placed into conservatorship. Or maybe, the regulator knows that over-reserving will deplete the company’s capital accounts and force it to take-down more of the Treasury’s senior preferred stock at the usury 10% rate.
Negative comments about the GSEs must be taken with a heavy grain of salt. The relentless pounding of these companies is part of the big bank/Wall Street agenda to control the mortgage market. Here’s an example of poor the analysis behind the criticism of the GSEs: http://blog.gatorcapital.com/126/rebuttal-to-gse-worthless-analysis/
Rebuttal to GSE Worthless Analysis
Oct/092
On Monday, the respected financial services boutique brokerage firm, KBW, published a report declaring the common and preferred shares of Fannie Mae and Freddie Mac to be “worthless.” The conclusion of the report was based on a contrived scenario where Fannie and Freddie are separated into good-bank/bad-bank entities and the future profits are diverted away from paying down the government’s ownership stake in the companies. If this scenario were to happen, it would be another huge subsidy for the big mortgage banking firms at the expense of taxpayers like you and me.
Bank Co-operative Model is a Bad Idea
Fannie and Freddie should not be restructured into bank-owned co-operatives. The brokerage report held up the FHLB System as a model for the future structure of Fannie and Freddie. The FHLB System is a poorly constructed system and is not an enviable model. The FHLB System allows the large banks to borrow money at government subsidized rates. The banks can use this borrowed money for any kind of lending they want such as auto loans, commercial loans, boat loans or even loans to foreign countries. This system has not prevented the FHLB Banks from posting large losses during the housing crisis. Another reason the FHLB System is bad is that it presents sizable systemic risks because it has no permanent capital. Members of the FHLB system can withdraw their capital on 90 days notice. In spite of nominally higher capital levels, the fact that FHLB capital is withdrawable makes the banks less stable than Fannie and Freddie. Moving Fannie and Freddie to a less stable capital structure is a bad idea.
Good-Bank/Bad-Bank Proposal Doesn’t Make Sense
Separating Fannie and Freddie into a good-bank/bad-bank as the KBW authors propose will not work because it is not a classic good-bank/bad-bank restructuring. First, in this proposal, the bad bank can’t support itself. Second, the authors transfer ownership of the good-bank to new owners. The concept of a good-bank/bad-bank split only makes sense if both entities are viable and self-supporting and have identical owners. The good-bank is a clean entity and can be more easily valued by the stock market. The bad-bank is capitalized to be self-standing and management can workout problem assets over time to realize maximum value without worrying about the timing of accounting gains or losses. The classic practical application was Mellon Bank in the 1980′s. In this report, the authors propose setting up the bad-bank as a non-viable entity from the start, and they assume a transfer ownership of the good-bank without any compensation. I submit that you can claim any financial institution in the country is worthless under the authors’ version of a good-bank/bad-bank scenario.
Holes in the KBW/GSE Model
There are multiple problems with KBW’s model that shows Fannie and Freddie having problems paying back the Treasury.
1. Bad-Bank Focus– As discussed earlier, as long as Fannie and Freddie are not separated into good-bank/bad-bank entities, they will be able to use revenue from new business to payoff the Treasury’s ownership position. Using the revenue from the good-bank will add $38 billion to Fannie and $25 billion to Freddie.
2. Double Counting Operating Expense – KBW’s model has operating expenses double counted. This adds $14 billion in expense to Fannie and $10 billion in expense to Freddie.
3. Severity Assumption is Too High – KBW uses 60% severity in its base case compared to John Hempton’s severity assumption of 45%. (BTW, the definitive analysis of the current value of Fannie and Freddie can be found in John Hempton’s series of blog postings on Fannie and Freddie.) I trust Hempton’s assumption more than KBW’s as he builds it up by vintage year. This accounts for $29 billion at Fannie and $15 billion at Freddie.
4. Mortgage portfolio run-off is much greater than mandated by Treasury – KBW assumes a run-off of the current on-balance sheet mortgage portfolio at a rate faster than mandated by the Treasury agreement. This accounts for $18 billion in lost revenue at both companies.
5. Assumed NIM is low – KBW assumed a 1% net interest margin which is low given the steep yield curve. If we assume Fannie and Freddie can keep their current margin for a three more years then revert to a 1% margin, it adds another $19 billion of revenue to both companies.
With these changes to KBW’s model, I calculate both companies can payback the Treasury:
($ billions) Fannie Freddie
Assumed shortfall from KBW model -49 -39
No good-bank/bad-bank separation +38 +25
Not double counting expenses +14 +10
Hempton’s severity assumption +29 +15
Slower portfolio run-off +18 +18
Current NIM +19 +19
New Capital Surplus +69 +48
With any model, the results are heavily dependent on assumptions. The user of a model must be well-versed in the assumptions before relying on its output. This analysis shows that by changing (and/or correcting) a few assumptions in the KBW/GSE model that the companies have plenty extra capital to pay back the Treasury, which is the opposite conclusion of the KBW report.
Another important assumption in the KBW model, which makes the GSEs’ capital positions look weaker is the assumption that they cannot raise capital from the public markets. Once the GSEs return to profitability, they may be able to raise equity to repay the Treasury.
Conclusion
The GSEs aren’t worthless until Congress restructures them and shareholders no longer have valid claims. Until Congress passes a law, the GSEs are working hard to mitigate their problem loans and to provide continued credit support to the housing market. Their income statements will flip from posting losses to reporting positive net income as we pass the peak loss years on the mortgages of 2006-2008. Freddie reported a profit in the last quarter, and it will be difficult to wipeout Fannie and Freddie shareholders once they return to sustained profitability.
Fannie and Freddie Model from Bronte Capital
Aug/091
John Hempton of Bronte Capital has written a fascinating series of articles on Fannie Mae and Freddie Mac. He models Freddie’s credit losses and revenues and comes to the conclusion that the company will earn its way to paying back the Treasury. He concludes that the way for investors to position themselves is to buy preferred stock in Fannie and Freddie.
Part I – Introduction and Where Losses Came From
Part II – Write Downs on Private Label Securities
Part III – Default Curves
Part IV – Estimates of Lifetime Defaults by Loan Vintage
Part V – Net Interest Margin
Part VI – Putting the Model Together
Part VII – Answering Criticsms
Part VIII – Risks
Not surprisingly, I completely agree with his analysis. I own a substantial amount of GSE preferred stock in Gator Financial Partners. In fact, it is, by far, my largest position.
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