Freddie Mac 2011 Q2 Earnings Review
Aug/1110
Last night Freddie Mac, which is in conservatorship, released its second quarter earnings. The headline numbers were a net loss of $2.1 billion and a requested draw from the Treasury of $1.5 billion. Although these results are worse than the first quarter report, there is an accounting entry which obfuscates the underlying progress Freddie is making in its return to profitability.
Freddie’s income statement shows more volatility than the underlying business because FASB requires the company to mark-to-market its derivative portfolio. When Freddie needs to issue long-term debt to fund its mortgage portfolio, it looks for the cheapest execution. It can either issue a cash bond with a fixed rate or it can replicate issuing a fixed-rate cash bond by entering into a pay-fixed swap and issuing short-term debt. In a pay-fixed swap, Freddie will pay the counterparty a fixed-rate and the counterparty will pay Freddie a short-term rate, which will be used to pay the rate on the short-term debt. Freddie will rollover the short-term debt until the pay-fixed swap matures. [I don't like this practice of substituting pay-fixed swaps for issuing long-term cash bonds because it exposes the company to financing risk. The company is constantly rolling over its massive portfolio of short term debt. It puts the company at risk when the capital markets close like in September 2008. However, it is what it is.] So over time, Freddie has entered into hundreds of billions of dollars of pay-fixed swaps. Every quarter, Freddie must mark-to-market this portfolio of pay-fixed swaps. When interest rates decline in a quarter like Q2, Freddie must report a loss, which it did to the tune of $3.4 billion.
If we are looking at Freddie’s income statement to get an idea of the company’s long-term performance and profitability, we need to ignore the derivatives mark-to-market line item. If rates rise the next quarter and this line item moves to a gain, then we’ll ignore it again. Eventually, this line item will be reflected in the income statement through net interest income. By ignoring the noise from the derivatives mark-to-market, we get a better sense of Freddie’s recurring earnings performance.
| 2011 Q2 | 2011 Q1 | |
| Net interest income | $4,561 | $4,540 |
| Loan Loss Provision | (2,529) | (1,989) |
| NII after Provision | 2,032 | 2,551 |
| Securities Impairment | (352) | (1,183) |
| Other non-interest income | 302 | 368 |
| Non-Interest Income | (50) | (950) |
| Non-Interest Expense | (546) | (697) |
| Income Before Taxes | 1,436 | 904 |
| Tax Benefit | 232 | 74 |
| Net Income ex-Derivatives | 1,668 | 978 |
| Other comprehensive income | 1,039 | 2,064 |
| Total comprehensive income | 2,707 | 3,042 |
So, from the table, we can see absent the derivative mark, the headlines should have read “Freddie makes $1.7 billion in the quarter and does require a draw from the Treasury.” I believe ignoring the quarterly mark on the derivatives portfolio gives a more realistic view of Freddie’s recurring earnings.
Here are some other observations from the Freddie’s 2nd Quarter earnings report:
1. Credit losses remained stable in Q2 at $3.1 billion compared to $3.2 billion and $3.1 billion in Q1 and Q4, respectively.
2. The loan loss reserve continues to look too high given the level of charge-offs. Freddie has more than 12 quarters worth of credit losses in its loan loss reserve. For comparison, Wells Fargo has 7 quarters of credit losses in its loan loss reserve.
3. I am not seeing evidence that Freddie has raised guaranty fee rates as the Treasury proposed in January this year. This may be because the rate is contracted with customers on an annual basis.
4. As of Q2, 46% of the portfolio was written after 2008. The legacy book is steadily declining and losses from the legacy book are declining.
5. Deliquencies for 30 days ticked higher in Q2, which reverses a multi-quarter decline in delinquencies.
6. Based on the interest rate moves in Q3, I would expect another sizable negative mark-to-market for the derivatives portfolio in Q3. It will probably cause Freddie to report another loss and draw again from the Treasury.
7. Q3 may be the last time Freddie has to make a draw from the Treasury if credit losses continue to stabilize or improve and the steep yield curve continues.
I continue to hold my positions in a few of the classes of Freddie Mac preferred stock. I think there is a chance that starting Q4, Freddie Mac will report profitable quarters and will be in a position to begin paying down the Treasury’s stake in the company.
Disclosure: Long FMCKJ, FMCKI & FMCCT
Disclaimer: There is no guarantee that Freddie Mac’s stock price will rise. There is significant risk that shareholders could be wiped out and you would lose all of your money. There are other reasons the stock may not perform. Please do your own analysis.
Updated Thinking on Fannie and Freddie
May/111
This post is an excerpt from the 1st Quarter Investor for my hedge fund. If you would like to receive a full copy of the letter, please send me an email at derek.pilecki@gatorcapital.com.
I have owned positions in Freddie Mac and Fannie Mae (the GSEs) preferred stock since the two firms were placed into conservatorship in September 2008. The shares have been extremely volatile. In the first five weeks of the year, the various classes of Fannie and Freddie preferred stock rose in price from about 2% of face value to about 6% of face value.
There are several factors that contributed to the value increase in these positions:
1. Fannie and Freddie’s financial results are improving – Both companies have improved their operations while in conservatorship. The new loans the companies have guaranteed in 2009, 2010 and going forward will be profitable. The problem vintages of 2005-2008 are being resolved and may be fully reserved for losses. In the meantime, the companies’ mortgage investment portfolios have been very profitable and are throwing off $16 billion of cash per year at each company. I believe Freddie Mac will become profitable in 2011 and Fannie Mae is potentially within 2 years of turning profitable. I believe the regulators have acted wisely in how they’ve managed Fannie and Freddie through conservatorship. Once the companies turn profitable, the nature of the policy debate will change for the better.
2. Realization that continued existence of the GSEs makes the most sense - The Republican success in the election of 2010 makes full nationalization of Fannie and Freddie unfeasible politically. On the other hand, the private market is not capable of providing enough capital to keep the mortgage market functioning smoothly especially at the low prices Fannie and Freddie charge to accept mortgage credit risk. Evidence that the private market is not capable and/or willing to supply capital to the mortgage market is Fannie, Freddie and FHA’s combined 95% percent market share of the mortgage market since 2008. The least risky option is to continue with the current system of the GSEs but impose tighter regulation on the companies to prevent bad management.
3. Recognition that Congress will not resolve the GSE issue soon - Rationality is returning to the GSE policy debate. Cooler heads are voicing their opinions that the GSE model is not broken. We are starting to see this point made from surprising sources such as Steven Roth’s annual letter to Vornado shareholders. The problem with the GSEs wasn’t their hybrid public/private model. The problem with the GSEs was incompetent management that did not recognize the danger of low documentation loans.
4. News that the GSEs asked the Treasury to reduce the coupon on its senior preferred stock – In late January, the Financial Times ran a story saying that management at both Fannie and Freddie asked the Treasury Department to reduce the 10% coupon it receives on its senior preferred stock. Freddie Mac may turn profitable this year even after paying over $6 billion in after-tax dividends to the Treasury. If the coupon rate was lowered, then Freddie could pay back the Treasury that much faster. Plus, the fact that management asked for the reduction confirms that the companies’ financial situations are in the beginning stages of recovery.
Of course, there should be several important changes to the GSE model to protect taxpayers, such as: Fannie and Freddie should not purchase mortgage loans without full documentation of income and assets, should not purchase private label mortgage securities, should step back from the market when spreads are tight and new business cannot meet their return on capital targets, and should restrict executive compensation. A final necessary reform is a requirement that any member of the board of directors be required to purchase an amount of common stock equivalent to a multiple of their annual directors’ fees with their own cash. This would incentivize board members to provide better oversight of management. As a shareholder, I wish all of these changes had been implemented years ago.
As Freddie turns profitable and recaptures some of the capital that is artificially hidden in its accounting statements (marks on private label securities, valuation allowance on deferred tax asset and generous loan loss reserve), I believe the potential exists for them to repay some or all of the Treasury’s investment. Once Freddie regains profitability and begins to repay the Treasury, a whole new set of policy options becomes available. These new policy options would be beneficial to preferred shareholders. It has been a long road owning Fannie and Freddie preferred stock, but the Fund has made a lot of money from the positions and the potential exists for future gains. Although these positions will continue to be volatile, I continue to see several scenarios with further upside.
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
Realtors Request Reduction in GSE Senior Preferred Dividend
Aug/102
Vicki Cox Golder, the President of the National Association of Realtors, sent a letter to Treasury Secretary Timothy Geithner requesting a retroactive reduction in the preferred dividend rate that Fannie Mae and Freddie Mac must pay the Treasury. The NAR argues that the high dividend rate is delaying the housing recovery, isn’t fair compared to the terms of the bailouts of the commercial banks and AIG, makes no sense to have negative compounding work against the GSEs.
What do you think of the NAR’s letter. How do you think Treasury will respond? Please post a comment.
The complete text of the letter follows:
August 13, 2010
The Honorable Timothy F. Geithner
Secretary
Department of the Treasury
1500 Pennsylvania Ave., NW
Washington, DC 20220
Dear Secretary Geithner:
On behalf of the 1.1 million members of the National Association of REALTORS® (NAR), I am writing to urge you to reduce, on a retroactive basis, the dividend rate on senior preferred stock issued to the U.S. Treasury Department in exchange for contributing capital to Fannie Mae and Freddie Mac to assure that they maintain a positive net worth.
The National Association of REALTORS® (NAR) is America’s largest trade association, including NAR’s five commercial real estate institutes and its societies and councils. REALTORS® are involved in all aspects of the residential and commercial real estate industries and belong to one or more of some 1,400 local associations or boards, and 54 state and territory associations of REALTORS®.
When Fannie Mae and Freddie Mac (the housing government sponsored enterprises, or GSEs) were placed into conservatorship by the Federal Housing Finance Agency in September 2008, the Treasury Department and each GSE entered into a contract providing for an initial $1 billion issuance of senior preferred stock with a 10 percent quarterly dividend, including warrants representing ownership of 79.9 percent of each GSE. Pursuant to the contracts, additional preferred stock has been issued in recent quarters as Treasury provided additional capital to each GSE to maintain their positive net worth. The agreements also provide for an additional quarterly fee starting in 2010.
Recent news reports have highlighted the 10 percent dividend that the GSEs are required to pay to the Treasury Department on the preferred stock. This dividend is twice the amount charged to banks that received assistance under the Troubled Asset Relief Program (TARP) and more than other firms have been required to pay in exchange for federal support. The Treasury-GSE contract imposes what we think is a punitive dividend that works as an unnecessary drag on the housing and economic recovery. The required dividend should be significantly reduced for a number of reasons.
First, the GSEs are working assiduously to reduce their losses, as they should. But the unintended consequence of their imposing high fees and very tight underwriting standards is to delay the housing recovery. NAR supports strong underwriting standards. In fact, NAR went on record, starting in 2005, at the beginning of the current crisis, warning about predatory lending, including the payment option adjustable rate mortgages and the “teaser” rate 2/28 and 3/27 mortgages that doomed so many homeowners to failure. We now just as firmly believe that the pendulum has swung too far and potential homeowners who are reasonable credit risks are too often unable to find a fair and affordable mortgage. As noted in one recent article, the GSEs’ current book of mortgage business is “pristine.” We think that achieving a pristine book of business means that the GSEs are falling short of their mission to maintain a liquid residential mortgage market, throughout the nation, that serves a wide range of borrowers, including qualified low- and moderate-income families. Reducing the current punitive dividend will enhance their ability to eliminate their losses, which will be further enhanced as the housing markets continue to stabilize and recover. This will give the GSEs the flexibility to adjust their underwriting standards to take into account reasonable lending risks, which will benefit the consumer and the entire economy, without undue risk of additional cost to the taxpayer.
Second, minimizing the amount of preferred stock held by the Treasury Department will make the challenge of restructuring the GSEs easier. One of the thorniest problems will be how to handle the amount of outstanding preferred stock held by the Treasury Department. From today’s perspective, it is hard to imagine how the capital infused into each GSE can ever be repaid. But whatever the solution, it will be easier if the obligation of the GSEs is not artificially increased by imposing the current punitive dividend rate at a level not imposed on banks or other firms, such as A.I.G., receiving government financial support.
Finally, it makes no apparent sense for the Treasury Department to transfer amounts to the GSEs so they will have enough money to pay the dividend back to Treasury. If the GSEs were not required to pay the 10 percent dividend, which significantly increases each of their quarterly losses, it would reduce the amount of additional capital Treasury is called upon to provide to them. The problem is exacerbated because a growing amount is necessary to pay the dividend on amounts received in order to pay earlier dividends. The “miracle” of compounding in this case has become a nightmare that is creating a permanent drag on the ability of the GSEs to fully achieve their mission. It would make more sense to charge the GSEs an amount equal to the Treasury borrowing cost, or the borrowing cost to the GSEs based on the current federal assurance that they will maintain a positive net worth. Both of these amounts are far less than 10 percent.
The interest of the National Association of REALTORS® in the relative financial health of the GSEs, in receivership, is based on the desire of our members for robust real estate and mortgage markets that recover as quickly as possible to assist the nation as it regains its footing after the worst economic downturn since the Great Depression. Regulators have many enforcement tools and the duty to ensure that finance corporations comply with laws, regulations, and sound underwriting. However, with respect to the GSEs, it appears that government policy has imposed a dividend rate and capital structure that singles them out for particularly onerous treatment. This strikes us as misguided at best and destructive to the housing market and economy at worst.
As you know, NAR does not defend past GSE practices that resulted in the conservatorship and recommends their total restructuring at the appropriate time. Eliminating a punitive dividend is a step that should be taken now, regardless of how the GSEs may be restructured in the coming years. NAR’s proposal for their restructuring is founded on eliminating the prior private profit and public loss structure, which was inherently flawed. We believe that it is the mission of the GSEs that must be protected, not their structure. For the benefit of homeowners, home buyers, renters, and the entire economy, the nation must have a way to assure the flow of capital to the mortgage market, regardless of the state of the housing or mortgage markets or the overall economy. The path out of receivership that achieves this result will be easier if the contract with the GSEs is amended to minimize the amount of preferred stock held by the Treasury Department.
Accordingly, NAR urges you to reduce, retroactively, the current punitive dividend rate now imposed on Fannie Mae and Freddie Mac, which together with the Federal Housing Administration, currently make possible the vast majority of mortgage lending. Doing so will speed our nation’s recovery and facilitate the movement towards a permanent GSE reform solution. If you would like additional information or an opportunity to discuss our concerns, please contact Jeff Lischer, NAR’s Managing Director for Regulatory Policy, at jlischer@realtors.org or 202.383.1117.
Sincerely yours,
Vicki Cox Golder, CRB
2010 President
National Association of REALTORS®
cc: Edward J. DeMarco, Acting Director, Federal Housing Finance Agency
So Where is GSE Reform Going, Anyway?
Jan/101
by Robert W. Zimmer
This Reuters article is the rare GSE journalist piece that calls it like it is. Let’s review the options laid out and see what’s what.
In religious wars, there are no innocent bystanders. This is certainly true for the multi-year tussle over the GSEs (Fannie Mae/FNM, Freddie Mac/FRE) and how they might fit or not fit in the US economic fabric going forward—and trust me, almost every journalist has an ax to grind one way or the other. In their heyday the GSEs were so big, so popular, and so powerful, that they swept skeptics and opponents out their way with ease—creating long-lasting enemies, including among the press.
Thus it is hard to find an unbiased viewpoint. Many journalists openly root for the GSE concept to fail and never raise its egotistical head again. Others take the contrarian view for sport. But finally there’s a piece that lays it out, with no agenda, and no ax. Let’s go over the Reuters piece in some detail.
Reuters: “That timeline (the unlimited backstop announced Dec 24) gives the Obama administration time to figure out what to do with the two entities since any changes are politically difficult and most analysts see the process taking years.”
Analysis: Dead on. The complexity of the secondary mortgage markets, combined with fear of yet-to-come exploding Option ARMS and weakening CRE markets, means there is no rush to “resolve” the GSE model legislatively. Washington policymakers want low interest rates and more modifications, and the conservatorship model is delivering them.
Reuters: “FULL NATIONALIZATION -This might be the easiest option and would return the companies to their origins as a government tool to nurture the housing market. Some analysts see the Obama administration’s Christmas eve move as a signal this is the direction they are leaning, but top White House economic adviser Lawrence Summers told the Wall Street Journal in late December “that certainly would not be the direction I would expect.” “
Analysis: Correct again. The “public option” didn’t work in the health care arena, and it won’t work here, especially as Republicans will undoubtably gain seats in the 2010 elections. And no one wants to further balloon the US budget deficit, which would happen if the GSEs were to be 100 percent nationalized. (Investors owning 20.1 percent of the companies, take heart! The US government can’t afford to take you out.)
Reuters: “PRIVATIZATION WITH PAYMENT FOR INSURANCE – Policy-makers might return the companies to investors and offer to insure Fannie Mae and Freddie Mac investments.
Washington could charge the companies a fee to underwrite their debt and some of their mortgage securities as a way to nurture the housing finance sector without standing squarely behind the companies. This idea, aired by Federal Reserve Chairman Ben Bernanke, would be akin to the Federal Deposit Insurance Corporation’s protection of banks.”
Analysis: Yes, an idea in play. This option recognizes that no one will ever believe going forward that the government wouldn’t step in again in times of debt market crises. So why not make the GSEs (and their shareholders) pay for the backing?
Reuters: “COOPERATIVES WITH LOOSE GOVERNMENT TIES – Fannie Mae and Freddie Mac could be run by the companies that sell them home loans. In such a cooperative arrangement, Fannie and Freddie would focus on long-term, stable business rather than maximizing profits. The federal government might still offer to insure the companies against the most catastrophic losses. This arrangement could be akin to the Federal Home Loan Bank system where a dozen regional lenders are jointly and severally liable for any one member’s losses and the federal government acts as guarantor of the entire system.”
Analysis: Dead wrong. The capital dedicated to cooperatives is not viewed as sufficiently flexible to support a dynamic mortgage market. More importantly, constituencies such as the Realtors and small bankers use the GSEs as a bulwark against the ever-larger, Federal-Reserve-leveraged, TARP-assisted Wall Street banks (does anyone believe THEY wouldn’t be bailed out again in a debt crisis?) that increasingly control the US mortgage market origination business—and these constituencies won’t tolerate the big banks controlling Freddie and Fannie via a coop model.
Reuters: “UTILITIES MODEL – Just like power and water companies that provide vital services, Fannie Mae and Freddie Mac could be run as private entities that have strong government oversight. The companies would aim to turn a profit and would have no government backing, but a conservative board would set earnings payments and customer fees.”
Analysis: Can’t rule this out. Stronger government oversight would have saved the GSEs from over-extending themselves in the bubble years, and a controlled ROE wouldn’t be the end of the world. And even guarantee fees could be subject to public rulemaking.
Reuters: “PRIVATE MORTGAGE-FINANCE COMPANIES – Although Fannie and Freddie are in government hands, their regulator is still trying to keep their shares trading. The agencies could emerge as large mortgage finance companies that bundle home loans for investors and raise funds in the traditional capital markets. Without government ties, though, the companies would not have lower funding costs and so would not enjoy the competitive advantage they do now. The federal government would also lose one of its most powerful tools for helping low-income home buyers. GAO said privatizing or terminating Fannie Mae and Freddie Mac would disperse mortgage lending and risk management through the private sector.”
Analysis: Not a chance. Full privatization would result in mortgage rates rising across the board by 50-100 basis points, and long-term, fixed-rate mortgages would be more difficult, if not impossible, to obtain. How many politicians want to get in front of THAT wagon? As for the GAO’s optimism of the private sector filling the space…really? Last time we checked, those guys checked out at the first sign of market instability. Anyone who has worked a day in finance knows that pure financiers are herd animals, which works well in most finance markets, but not the mortgage one.
Reuters: “COVERED BONDS – Covered bonds could become a mortgage finance tool to rival the influence of Fannie Mae and Freddie Mac. Unlike traditional mortgage-backed securities, which are frozen blocks of home loans, covered bonds allow banks to manage a dynamic pool of mortgages. This financing tool is popular in Europe but has a weak foothold in the United States because of regulatory constraints and the competitive advantages of Fannie Mae and Freddie Mac. The fate of those companies will have a direct impact on the future of covered bonds. “
Analysis: Covered bonds certainly have a place in the market going forward, but for reasons beyond the scope of this article, they can’t replace the securitization and retained portfolio model of the GSEs entirely. They will supplement, not replace, the function of the GSEs.
Conclusion: The Reuters piece is an excellent piece of reporting. With an overlay of basic political analysis, we can further narrow the scope of the ultimate options that will be debated by policymakers in Washington. And someday—believe it or not—the religious wars over the GSEs may actually reach an end. And we’ll all be better off for that ending.
Robert W. Zimmer is Principal at TVDC, a Washington-based financial services consulting firm.
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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