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.
Make Fannie’s Deal No Worse Than TARP
Aug/090
Given Freddie Mac’s recently report profitable 2nd quarter earnings report, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.
Reasons to Change Fannie and Freddie’s Deal with the Treasury
1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut 4 weeks before TARP.
2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson.
6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock. It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios.
9. GSE preferred stock is still primarily owned by small banks. When dividends are restored, the value of the preferred stock will increase by 10x. This will add approximately $30 billion in restored capital to the commercial banking industry. If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.
Terms to Change
1. Lower Preferred Stock Coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point. We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.
The GSEs deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.
Credit Score Interview
Aug/091
This morning, I was interviewed by a local student about credit scores. Here is the Q&A:
1. What are the implications of having either a positive or negative credit history? (give specific examples)
Answer: Your credit score clearly affects your ability to get access to credit. A few years ago, a low credit score simply meant you paid a higher interest rate on your car and mortgage loans. Today, a low credit score likely means you can’t get a loan at all. Also, financial companies besides lenders use credit scores as well. Apartment landlords will use credit scores to determine whether you’ll fulfill the terms of a lease. Insurance companies will use your credit score to determine if you are good risk for car and home insurance. While a credit score measures how much debt you have, it is mostly based on your record of making bill payments on time. Insurance companies have proven statistically that people with low credit scores are more likely to have accidents and make claims than people with higher credit scores. They rationalize that people who make sure to pay their bills on time are probably cautious in other aspects of their lives like driving and will have fewer claims.
2. What would constitute a responsible use of credit?
Answer: A good use of credit is to make a purchase that will either increase your income or reduce your expenses. For example, you may live in an area where there are no jobs within walking distance, so you borrow money to purchase a car. Now, you are able to drive to get to a job that will pay you enough income to repay the car loan and have money for living expenses.
3. What are three (or more) inapproriate uses of credit?
Answer: An inappropriate use of credit is to make consumable purchase that you cannot afford. For example, you live paycheck-to-paycheck without any saving any money. You decide to purchase several new outfits because fashions have changed. You reason the minimum monthly payment required by the credit card company is only $25. This is inappropriate because you may not be able to make the payments and the amount of time it will take to repay the credit card will exceed the time the clothes are still useful.
4. When selecting a credit card, what factors should one consider?
Answer: When selecting a credit card, the factors that matter most are the annual fee, the interest rate charged, the length of grace period, and any rebates or rewards offered by the credit card company. Personally, I use the American Express Blue Cash Card because I payoff my bill every month, I don’t even know what my interest rate is. However, I know that I have no annual fee and get 1.5% cash rebate back on all of my purchases.
5. Do you think high school students should have credit cards? Why or why not? Explain.
Answer: High school students should not have credit cards because most do not have any income for repayment of their credit card debt. Another reason high school students should not have credit cards is the peer pressure young people feel for conspicuous consumption. In today’s society, there are constant marketing messages about successful people enjoying their money through spending. It is as though you need to spend to show that you are successful. Well, you can also borrow money to spend so that you look successful. In my business of giving financial advice to people, I meet many people who drive BMWs but they don’t have enough savings to become my client. The way to financial independence is through savings. This lesson is not taught to high school students. I fear the pressures to spend would lead too many high school student to use credit inappropriately. In today’s cashless society, high school students may not want to use cash for normal purchases, so I would suggest getting a student or free checking account at a local bank and asking for a debit card linked to the account. This way the student will only make purchases when they have money in the account.
Inherited IRAs
Aug/090
When our loved ones die and leave behind assets in an IRA account, it is an opportunity to make sure we benefit from continued tax-deferral of investment assets. Tax deferral is one of our favored strategies for building wealth, and we need to preserve tax-deferral whenever we have the opportunity. This article will help guide you through the decision points of an inherited IRA. You’ll need to know:
1. The type of IRA beneficiary – spouse, non-spouse, estate, trust or charity.
2. The type of IRA – Traditional or Roth.
3. The age of the IRA account owner at the time of death.
4. The date the IRA account was opened if a Roth IRA.
Spouse Beneficiary
A spouse inheriting an IRA has the most options, but most likely has the easiest decision.
1. Spousal Transfer – You move the assets into your own IRA (an existing one or a new account set up for the purpose). You get to treat the assets just like your own IRA holdings, and they are subject to all the rules that apply to you as an IRA holder. You get to designate your own beneficiary. Spouses who are not the sole beneficiaries are not allowed to use this option. We would recommend most every sole beneficiary spouse take this option and perform a spousal transfer.
2. Lump Sum Distribution - All the assets are withdrawn, immediately. If the funds are subject to taxes, they must be paid all at once. There is no early withdrawal penalty. We would only recommend this option to a spouse who is significantly far away from reaching 59 and 1/2 years and will need the money immediately.
3. Inherited IRA 5-year option - The assets are transferred into a special IRA account called an Inherited IRA and must be distributed by the end of the fifth year after the death of the original account holder. You get to designate your own beneficiary. This option is not available if your spouse was over age 70 1/2. We don’t see a need for a spouse as sole beneficiary to use this option.
4. Inherited IRA Life Expectancy option – The assets are transferred into an Inherited IRA account (or separate Inherited IRA accounts, if there are multiple beneficiaries) and annual distributions are made based on the life expectancy of those who have inherited the IRA. You get to designate your own beneficiary. We don’t see a need for a spouse as sole beneficiary to use this option.
Non-spouse Beneficiary
A non-spouse inheriting an IRA has fewer options.
1. Lump Sum Distribution - All the assets are withdrawn, immediately. If the funds are subject to taxes, they must be paid all at once. There is no early withdrawal penalty. We would only recommend this option to a person who is significantly far away from reaching 59 and 1/2 years and will need the money immediately to payoff debt or for other major expenses such as paying for college.
2. Inherited IRA 5-year option - The assets are transferred into a special IRA account called an Inherited IRA and must be distributed by the end of the fifth year after the death of the original account holder. You get to designate your own beneficiary.
3. Inherited IRA Life Expectancy option - The assets are transferred into an Inherited IRA account (or separate Inherited IRA accounts, if there are multiple beneficiaries) and annual distributions are made based on the life expectancy of those who have inherited the IRA. You get to designate your own beneficiary. We see this as the most popular option for non-spouse beneficiaries option.
This information is intended to give a quick overview of the issues related to inherited IRAs. We suggest seeking the advice of a tax attorney. Also, please use the IRS publication on this topic.
If you would like to discuss you Inherited IRA situation in more detail, please call me at (813) 282-7870 or send me an email at derek.pilecki@gatorcapital.com.
Derek Pilecki
Gator Capital Management
(813) 282-7870
derek.pilecki@gatorcapital.com
Roth IRA FAQ
Aug/090
I recommend my clients use a Roth IRA to grow their retirement savings tax-free. Because I know the various types of IRAs can seem a little confusing, I thought I’d take some time today to answer the questions I get most often from clients.
What is a Roth IRA?
The Roth IRA is a type of individual retirement account that features tax-free withdrawals because the original contributions are made with after-tax money.
What’s the difference between a Roth IRA and traditional IRA?
There are several differences. The main one is when you pay taxes. With a traditional IRA, you invest pre-tax dollars and defer paying income tax until you take the distributions from the account during retirement. With a Roth, you pay income tax on the dollars you’re investing now—but when you take the distributions, they’re tax-free.
Other important differences have to do with the timing of your withdrawals. With either type of IRA, you need to wait until age 59 ½ to make withdrawals. But with a traditional IRA, you must begin making withdrawals at age 70 ½, or else you will face penalties. With a Roth, there is no required minimum distribution. If you don’t need the money in your Roth IRA when you’re 70 ½, you can leave it there to keep growing.
Am I eligible to set up and contribute to a Roth IRA?
In order to contribute to a Roth IRA in 2009, you need to have taxable income for the year, and your adjusted gross income must be less than $166,000 if you are married filing jointly or $105,000 if you are single. (In addition, there’s a category in which you are allowed to contribute but your contribution limit is lower: for those married filling jointly whose AGI is between $166,000 and $176,000 or single with AGI between $105,000 and $120,000).
How much can I contribute to a Roth IRA?
In 2009, you can contribute up to $5,000 or up to $6,000 if you are 50 or older. If you are also contributing to a traditional IRA, then your total contributions to both IRA accounts may not exceed these same limits (so, for example, if you are under 50 and you put $2,500 into a traditional IRA, then you may only put $2,500 into a Roth IRA).
When can I set up a Roth IRA?
You can set up a Roth IRA at any time. You can make contributions for the previous year up to the date your taxes are due. For most people, then, you can make contributions for 2009 up until April 15, 2010. (This can be useful if you decide to set up a plan in January and want to make up time by, say, contributing 2009’s total early in 2010 and then making contributions throughout the year for 2010.)
Will I save more on my taxes with a Roth IRA or a traditional IRA?
Generally, you will have higher after-tax returns with a Roth IRA. One of the benefits of a Roth IRA that I haven’t mentioned is you effectively are able to put more after tax money into tax-deferral with a Roth IRA. For example, if you make a $5,000 contribution to a traditional IRA, you are investing $5,000 of pre-tax money in to a tax deferred account. If you took that same $5,000 of pre-tax money and invested in a Roth IRA, had the same investment experience and had the same tax rate at retirement that you have now, you would have an identical sum to the traditional IRA. However, because the $5,000 of pre-tax money is $3,600 of after-tax money (assuming a 28% tax rate,) you can effectively save $1,400 more after-tax with a Roth IRA.
One factor that can work against you in a Roth IRA is if you are currently in a high tax bracket and expect to be in a lower tax bracket in retirement. However, because of the advantages of higher after-tax investment and the no required distribution aspect of a Roth IRA, I generally think the Roth IRA is a good choice for most people.
What are Roth IRA Qualified Distributions?
Qualified Distributions from a Roth IRA are tax and penalty free. In order to be a qualified distribution, there are two requirements that must be met:
1. The distribution must occur at least five years after the Roth IRA was first established and funded; and,
2. One of the following requirements also must be met:
a. The Roth IRA owner must be at least age 59 1/2 years old,
b. Distributed assets limited to $10,000 are used towards the purchase of a first home for the Roth IRA holder or a qualified family member,
c. The Roth IRA owner is disabled; or,
d. The assets are distributed to the beneficiary of the Roth IRA owner after the owner’s death.
Distributions that do not meet the above criteria are considered non-qualified and may be subject to income tax and a 10% early distribution penalties.
Are there any other allowed early distributions from a Roth IRA?
In addition, the 10% early penalty is also waived for certain other distribution reasons. But, for these distributions, taxes on any earnings will apply. The types of distributions that are subject to taxes on any earnings withdrawn but with no penalty include:
1. Substantially equal periodic payments,
2. Eligible medical expenses in excess of 7.5 percent of your adjusted gross income (AGI),
3. Medical insurance premiums for eligible unemployed individuals,
4. Qualified education expenses; and,
5. Distributions taken within the first five years for any of these reasons: age 59½, death, disability, or first-time home purchase.
Distributions taken for any reason other than a qualified reason or one of the reasons here are subject to both taxes and a 10 percent IRS penalty on any earnings withdrawn.
Are the investment options the same for Roth as for traditional?
Yes, just as with a traditional IRA, funds inside a Roth IRA can be invested in a wide range of securities, including stocks, bonds, and money market accounts. Your exact investment options will depend on the financial institution where you set up the Roth IRA account. We custody our clients’ Roth IRA accounts at Fidelity Investments because of there are no annual fees, discounted brokerage commissions, and strong investment platform with many investment options.
Can I leave my Roth IRA to my heirs?
Yes, and this is another area in which the Roth has some advantages; unlike with a traditional IRA, your heirs can keep the inherited money from a Roth IRA in the account beyond the time when you would have reached 70 ½. Since there are no required minimum distributions, you heirs will join the opportunity to compound their investment returns tax-free for a longer period of time than if you had a traditional IRA.
How Do I Open a Roth IRA Account?
We would be happy to help you open a Roth IRA account. As we mentioned, we have our clients open their Roth IRA accounts at Fidelity Investments. Please call me at (813) 282-7870 or send me an email, and we’ll help you open your Roth IRA account.
Derek Pilecki
Gator Capital Management
(813) 282-7870
derek.pilecki@gatorcapital.com
Anti-Government Banker Builds Career on Government Subsidy
Aug/090
This weekend’s New York Times had a flattering Andrew Martin article on BB&T’s John Allison. I think it is joke for Allison to benefit from a huge government subsidy like FDIC insurance and at the same time, to present himself as anti-government/objectivist. His thought process is intellectually dishonest. He talks as though banks are purely private institutions and would still exist in their current form without FDIC insurance. I have news for him: banks exist today only because of the federal government provides backstop FDIC deposit insurance.
FDIC insurance is a large government subsidy program to help bankers attract deposits. FDIC insurance is critical to a bank because most of the value of a bank comes from its deposit base. With FDIC insurance, bank customers (depositors) are indifferent to the safety of the bank. Instead, depositors base their choice of banks based on rates offered, levels of customer service and branch locations. Without FDIC insurance, banks would have to run with much lower levels of leverage and much high levels of liquidity to attract deposits based on safety and stability. These measures would guard against bank panics or runs; however, lower leverage and higher liquidity would also dampen profitability for the bank.
Another beef I have with Allison is his blaming the housing crisis on Fannie and Freddie. It has been well documented that Wall Street led the credit bubble in the housing market with the expansion of the non-agency mortgage market, specifically the explosion in subprime and Alt-A lending. Fannie and Freddie lost market share from 2002 to 2007. If they were losing market share, how did their actions lead the housing market to its bubble status? See the series of articles on Univ. of Oregon Prof. Mark Thoma’s blog for a more complete discussion on how Wall Street led the mortgage market to a credit bubble. Allison’s blame of Fannie and Freddie seems like a convenient, popular position that fits into his distorted anti-government view.
If Allison truly wants to prove he lives his life abiding by Ayn Rand’s objectivist philosophy, he should have BB&T’s board vote to renounce the company’s bank charter. Then, we’ll see how long a bank run by an objectivist is able to maintain its depositor base and remain in business. I suspect the bank wouldn’t last long.
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