MonkeyBusinessBlog

In Honor of Freddie and Fannie's One Year Anniversary a Repost of "When Freddie and Fannie are Nationalized Who is Going to Watch Their "Other" Nuclear Arsenal?"

The Financial Times has a piece out today Houses to Put in Order. It seems like just yesterday that Hank Paulson had to take his infamous "bazooka" (remember that bit of inanity?)  out of his pocket and put Fannie and Freddie under the Treasury's wing.  

Last July I wrote a post that I feel is worth re-posting because quite frankly, I haven't heard a single solitary word about how the government is going to manage Freddie and Fannie's $1 trillion+ retained portfolios.  The management of these portfolios (and when I wrote this, Freddie and Fannie had not yet become the Government's repository of "unique" loans) is incredibly complex and mismanagement will lead to $ billions of losses.  We may never officially "see" those losses now that Freddie and Fannie are public companies in name only, but be assured that they will be there.  Here is the re-post from last July;

When Fannie & Freddie Are Nationalized, Who is Going to Watch Their "Other" Nuclear Arsenal?

Do you remember back to the early 1990's when the old Soviet Union collapsed?  We were all so ecstatic that our long time foe was seemingly vanquished and The Cold-War was over.  I had a very good friend who worked for a certain institute that monitored the proliferation of nuclear weapons.  The institute of course, was really just a cover for C.I.A.  My friend told me that they were scared sh*tless that as the Red Army collapsed, who was going to watch the arsenal of nuclear weapons and vital components to make or deliver nuclear strikes that the Soviet Union had been building for years?  The armed forces of Russia were essentially being cut loose to fend for themselves.  The poor non-officers were begging for food in the street, in uniform!   As for the high ranking officers, they were either leaving to make money in this new Russia, or NOT LEAVING the armed forces to make money.  How were they making money you ask?  The were selling vital nuclear, biological and chemical weapon components to just about ANYONE that had the cash. In the 1990's, our biggest fear was, "Who is watching the Russian WMDs?"  The answer really was, hardly anyone we could trust to either be competent or non-corrupt.  We are seeing the nasty fruits of this decade of neglect now as WMD proliferation expanded rapidly.

Now, lets use this analogy for Freddie and Fannie because they have their own financial version of a nuclear arsenal!  Their retained portfolios (about $1.5 trillion) are predominantly prime mortgages funded with agency debt.  Managing the interest rate risk of these portfolios is a MASSIVE undertaking.  The interest rate risk of mortgages is extremely complicated because, embedded in each loan in a pool that makes up a mortgage-backed-security is the borrower's option to refinance.  I'm not going to get into a long dissertation on managing mortgage interest rate risk here but we can talk about the basics.

When rates fall, more borrowers prepay their existing 6.5% mortgage and refinance into a 5.5% mortgage.  Conversely, as rates rise, less borrowers prepay their mortgages.  Therefore, the duration of the mortgage portfolio goes down substantially when rates fall and increases substantially when rates rise.  This creates serious duration risk mismatches between the mortgage assets and the funding liabilities. To put it bluntly, if you funded a portfolio of Fannie Mae or Freddie Mac mortgage-backed-securities with five-year Agency debt, you would getting short duration as rates fall and long duration as rates rise and you would lose lots of money.

This is called convexity risk.  Up until recently, this was the main focus of GSE risk.  To properly hedge this risk you have to buy options in the derivative market and in the agency-debt markets by issuing callable debt.  Essentially, you have a extremely complicated book of assets, liabilities and interest rate options.  If you mismanage this portfolio you can lose many billions.  We know this because Fannie Mae lost tremendous amounts of money in the years 2001-2004 because they didn't manage the risk right, and for a period, hardly at all!  This led to their accounting scandals to hide these losses, pump up profits and get their executives paid handsomely.  Fannie is now much more focused and competent in managing this risk than they were earlier in the decade.

Freddie Mac on the other hand, was always very good at managing this risk.  In fact, Freddie used interest rate derivatives so adeptly to manage this risk that when a change in accounting rules forced the mark to market of the derivatives, Freddie had so much extra profits in 2001-2003, that they played all sorts of accounting scams to "save the gains" for future years.  As you probably remember, they got into huge trouble over this.  Freddie remains highly vigilant and competent at managing this risk.

Now, lets take a scenario where the GSEs come under control of the government.  There really are only a handful of people at Freddie and Fannie that have the expertise to manage the retained portfolios.  What is going to happen when large portions of their personal net worth are wiped out when their restricted stock goes to zero?  What is going to happen when these few see that their careers at these two institutions are a dead end.  I'm not telling anyone to feel bad for them, but the reality of those people either leaving or not caring is a frightening one.  They very well might become like the Red Army circa 1995. Who is going watch and maintain the financial version of a huge nuclear arsenal?  We better get those questions answered or the U.S. taxpayer is going to end up losing a whole lot of additional money from a place they aren't even aware of.

I May Have Been At the Meeting Where The Credit Crisis Was Born!

A little while ago a colleague asked me, "Who do you think is the number 1 villain in the credit crisis?" I thought about it for a minute and I said, "I think that I would have to go with Countrywide's  Angelo Mozilo.  The reason I named "Orange Angie" was because I used to work at Freddie Mac.  Among the many things Mozilo did, he really bullied the crap out of Fannie and Freddie to loosen underwriting standards for prime loans and get involved guaranteeing subprime and Alt-A garbage.  Mozilo essentially told Fannie and Freddie in the middle of the decade that he didn't need them anymore.  The Wall Street securitzation machine was taking down his product and guaranteeing it for a hell of a lot less than Freddie and Fannie were willing to do it.  Sure, Freddie and Fannie were big boys and they did what they did on their own volition.  Still, Mozilo helped guide them down the road to credit hell and without that trip, the world would be a different place today.

Anyway, this got me thinking about how this whole thing got started.  I started working at Freddie Mac December 1998.  My original job was Director of Risk Management for Freddie Mac's mortgage backed securities dealer "Security Sales & Trading Group."  They were growing the dealer so they brought me down from Wall Street to build the risk management function.  Anyway, I did that job for about a year and then they asked me if I wanted to be the strategist as well.  I figured what the hell so I said yes.  When you think about trade ideas for Freddie and Fannie MBS, one of the most important assumptions is how fast or slow will a portion of the loans pay off.  When interest rates fall, borrowers in the pool of mortgages refinance.  The trick is making an educated guess as to how many would refinance and prepay their existing mortgage, and how fast would they do it.

Sometime in early-2000 I get invited to a meeting.  At the meeting, some of the people who worked at another department in Freddie Mac told us about a new origination program called "Fast Docs".  They told us that the big shops like Countrywide complained bitterly in the last refinancing wave (1998-1999) that Freddie and Fannie's underwriting rules were way too cumbersome for refinancings.  Their biggest beef was;

"If a guy just took out a 7% mortgage eight months ago, and we fully underwrote his loan and you guys (FRE or FNM) guaranteed it, why the hell should we have to fully underwrite him again, less than one year later?  You guys have already took credit risk on him.  As long as the house is still there, there are no other liens on the house in front of us, and the guy isn't asking for a higher loan balance, why do we have to redo all the job and income verification and full appraisal?  We have a big database of home prices, we can do a basic drive-by appraisal, a title search and blast the guy a new loan."

Apparently the big guys were bitching about this all through 1999.  Freddie and Fannie were slowing them down and costing them money.  They made all kinds of threats that they were going to go private label and cut Freddie and Fannie out (which they ended up doing a few years later) unless the GSEs played ball.  They also played one GSE against the other, which they fell for, hook, line and sinker.  Eventually, both GSE's gave in.  It seemed like it made sense.  If I already guaranteed that you were going to pay your $200,000 7% mortgage and you were current on it, it could only help our credit situation if the guy reduced his coupon to 6%.  All else equal, we just improved the guys cashflow situation.  It kind of made sense.  Fast Docs was launched and it became a way of doing business of $trillions of refinancings going forward.

Unfortunately, these lax underwriting standards being done in such size became a way of life.  Big firms like Countrywide got used to this new, easy and fast way of doing business.  They and the rest of the originators were big mortgage factories and like any other factory, its all about getting as many units through the line as quickly and cheaply as possible.  What started as a reasonable operational request in 1999, turned into the "No income, No appraisal" underwriting standard of the 2000's.

That is where I think the great credit crisis of this decade started, back at the GSEs ten years ago!  

Freddie Mac Shows the Way Forward!

Great article in America's best business section, The New York Post Freddie Mac Attack.  Talk about a story with delicious irony.  In one story we get to examine;

• The disaster in commercial real estate financing.
• The continued nonsense from the GSEs even AFTER their humbling government takeover.
• The sick comedy with our debt rating process.

From the New York Post;

Think of it as a Freddie smack.

Government-owned Freddie Mac has snubbed the two leading rating agencies -- Moody's Investors Service and Standard & Poor's -- on the plum assignment of rating the market's first securitization in nine months, relying instead on the market's two smaller rating agencies.

Instead of going with Moody's and S&P, the industry standard, Freddie will have AAA ratings from Fitch and Canadian agency Dominion Bond Rating Services on its $1B deal.

According to people familiar with the matter, Moody's and S&P lost the Freddie mandate because the ratings method they applied was considered too rigorous.

That's not to say that snubbed firms would have granted the deal something less than a AAA rating, a source noted. However, the ratings firms required Freddie to sign documents that freed them from blame in case anything went wrong with the bonds.

This is hysterical....in a sick sort of way.  The government is desperate to head off the oncoming category 5 commercial real estate hurricane by using Freddie and Fannie to provide liquidity to the sector.  They both have sizable multi-family portfolios to begin with, but what I think is happening is the government wants to ramp it up big time (the guarantee part of the business) to get as many multi-family loans refinanced as they can.  I am sure that the underwriting process will be relaxed considerably, leaving you and I (the tax-payer) with our tushies hanging in the breeze.  Oh, and lets not forget that the government will be providing nice non-recourse financing to investors through TALF!

Meanwhile, S&P and Moody's are looking at the billions of CMBS drek that they rated over the last few years and are essentially saying, "We'll put our discredited stamp of approval on this sucker, but you have to sign a bunch of documents absolving us from misrating the bond." 

Then you have Freddie, pretending that it's 2001 by telling S&P and Moody's, "If you aren't a team player, we'll just cut you out and find somebody that will put a AAA stamp on the bond.  You guys are in the box!" 

As Tony Soprano said, "The hustle never ends."

Freddie Was Pressured By Regulator Over Accounting Disclosure.

Back on March 2 when Freddie Mac CEO David Moffett resigned, I wrote this;

From Bloomberg News;

March 2 (Bloomberg) -- Freddie Mac Chief Executive Officer David Moffett resigned six months after being tapped by the government to lead the second-largest U.S. mortgage finance- company amid the housing slump. Freddie said that Moffett, 57, “indicated that he wants to return to a role in the financial-services sector,” and a spokeswoman said he wasn’t asked to step down by the company’s regulator or the Obama administration. McLean, Virginia-based Freddie said in an e-mailed statement today that it expects to name an interim replacement before March 13.

Allow me to translate Mr. Moffett's explanation of "wanting to return to a role in the financial services sector"

"I did not know when I was tapped for this gig that I was to be little more than the head security guard at "The Mall of Forgotten Toys."  I thought there would at least be some financial management going on.  Instead my job is to buy whatever toxic garbage Treasury tells me to buy as well as guarantee mortgages that go against our GSE charter.  I've been around the block a few times and I know as sure as the sun rises in the east and sets in the west, when we announce a $75 billion quarterly loss due to this activity at the end of 2009, I'll get blamed and NOBODY at Treasury will come to my defense."

Today in The Washington Post Zachary Goldfarb wrote Freddie Pressured Over Accounting Disclosure.

Freddie Mac's regulator pressed the company to withhold information related to the proposal from a federal filing, concerned that this seemingly arcane discussion of accounting practices could add billions of dollars to the government's cost of bailing out financial firms, two people familiar with the matter said.

But the company's executives refused, the sources said. They worried that removing the information from the report to the Securities and Exchange Commission could expose them to accusations they'd hid required details from regulators.

Freddie management was rightfully concerned that if they didn't properly account for the activities they were taking, on behalf of the Treasury Department, and didn't discuss them with the SEC, they would be open to charges that they withheld information from investors.  Freddie Mac is still a public company.  More from Goldfarb's article;

In March, Freddie Mac executives, including Kellermann, had tussled with FHFA over whether to disclose to investors that government management was undermining profitability and may cost the company about $30 billion, sources familiar with the dispute said. The regulator had urged Freddie not to do so, three sources said. The company threatened to appeal to the SEC and ultimately disclosed the possible cost. An FHFA official has said that it did not try to prevent the disclosure.

This potential expense was related to the Obama administration's housing recovery program, for which Freddie Mac playing a part in modifying the mortgages of homeowners facing foreclosure. Many of these loans had been bundled into securities. So to modify the mortgages, Freddie Mac has to pluck them out of the securities, which entails reassessing the value of the loans and marking them down to their current market price. The company might then have to record a charge to reflect these decreased values.

The article goes on to point out that Freddie was also pressured not to send a pre-filing memo to the SEC that detailed the different accounting methods that might be applied, regarding the loan modifications.  One of the accounting methods that Freddie rejected as not properly conservative, was one being used by Fannie Mae.  The FHFA didn't like that and since they monitor communication between Freddie and the SEC, pressured Freddie not to send the memo.  The FHFA of course, denies putting any pressure on Freddie.  Read the article.

We are really starting to get a very disturbing picture around how the government has been disregarding the law to get the results they want.  Is Ken Lewis lying about the pressure put on him to close BofA's purchase of Merrill Lynch?  Are the Non-TARP creditors lying about being threatened by the government to play ball in this Chrysler deal?  Is Freddie lying about this story?  I don't think so.  I think what I wrote back in March about David Moffett's resignation was on the money and I'm no genius or swami.  The rule of law works both ways and breaking it in the name of the ends justifying the means isn't what the U.S.A. is all about.

Fannie And Freddie Need Less Aid With New Accounting Rules!!

From Bloomberg News;

April 2 (Bloomberg) -- Fannie Mae and Freddie Mac, the mortgage-finance companies that have taken $60 billion in taxpayer-funded capital, will have less need for additional aid under new accounting rules for losses, their regulator said.

The Financial Accounting Standards Board, or FASB, approved rules today that give financial companies more latitude to use their judgment, instead of market prices, in determining changes in the value of assets, including mortgage-backed securities. The rule can be applied to first-quarter results and beyond.

The change has “the potential to have a positive effect on both earnings and shareholders’ equity, which would decrease potential future draws” by Fannie and Freddie from a $400 billion emergency Treasury fund, Corinne Russell, a spokeswoman for the Federal Housing Finance Agency, said in an interview.

This is absolutely amazing!  That's all it took folks, change the accounting.  What the hell was the big deal about???  With the stroke of a pen everything is just fine!  This FASB "Mark-to-Whatever Blows Your Dress Up" ruling is like the entire system has taken a gigantic dose of nembutal!  How freaking stupid is it going to look when they get to mark these securities back up (and I thought they had avoided marking $ billions down...the old "Temporary Loss" bucket), and then the bonds get downgraded AND start taking principal losses??  The morons are just going to have to come back to Congress and ask for the money they gave back, or I guess ask for the money that they suddenly don't need anymore!

If anything could crystallize what a circle jerk this FASB ruling is, this is it!

Freddie Posts $24 Billion Loss and Draws $30 Billion From Treasury Line. In Other Local News, Man Bites Dog.

From Bloomberg News;

March 11 (Bloomberg) -- Freddie Mac, the mortgage-finance company thrust into a leading role in President Barack Obama’s homeowner rescue plans, said it will tap $30.8 billion in federal aid as deterioration in its loan holdings led to a record loss.

The company, which owns or guarantees more than 20 percent of U.S. home loans, today reported a wider fourth-quarter net loss of $23.9 billion, or $7.37 a share. The results pushed the value of Freddie’s assets below its liabilities, the McLean, Virginia-based company said in a statement, and come as Chief Executive Officer David Moffett leaves after six months on the job.

Nice going Moffett!  Just kidding, it certainly wasn't his fault.  Boy, what a sign of the times.  Freddie drops nearly $24 billion in a quarter and no one seems to care.  What's scary is, how much are they going to lose after they REALLY start buying or guaranteeing the greater than 100% Loan to Value mortgages, let alone all the other freaks of finance they will wave in during the dead of night?  Maybe we should invoke the mercy rule and stop keeping score.

Freddie Mac's CEO Resigns.

From Bloomberg News;

March 2 (Bloomberg) -- Freddie Mac Chief Executive Officer David Moffett resigned six months after being tapped by the government to lead the second-largest U.S. mortgage finance- company amid the housing slump. Freddie said that Moffett, 57, “indicated that he wants to return to a role in the financial-services sector,” and a spokeswoman said he wasn’t asked to step down by the company’s regulator or the Obama administration. McLean, Virginia-based Freddie said in an e-mailed statement today that it expects to name an interim replacement before March 13.

Allow me to translate Mr. Moffett's explanation of "wanting to return to a role in the financial services sector"

"I did not know when I was tapped for this gig that I was to be little more than the head security guard at "The Mall of Forgotten Toys."  I thought there would at least be some financial management going on.  Instead my job is to buy whatever toxic garbage Treasury tells me to buy as well as guarantee mortgages that go against our GSE charter.  I've been around the block a few times and I know as sure as the sun rises in the east and sets in the west, when we announce a $75 billion quarterly loss due to this activity at the end of 2009, I'll get blamed and NOBODY at Treasury will come to my defense."

Smart man in my opinion.  Maybe the first one they've ever had at the helm of that shop! I really think Ed Liddy over at AIG should be watching this.

Housing Plan Running Into Those Pesky Details Again!

Article from Bloomberg News today bringing to light some legal tripwires the Obama housing plan is hitting with regard to Freddie and Fannie's charter. Obama's Mortgage Plan for Freddie, Fannie May Face Legal Snag.  For a group of people (government) that has a heavy overweight in the legal field, they sure do like to ignore the law!  Like Tom Cruise said to Demi Moore in "A Few Good Men", "Oh, that's right..I forgot you were sick the day they taught law in law school!"

The main issue here is that Freddie and Fannie's Government Sponsored Enterprise Charters specifically state that the GSEs will only buy or insure a loan that has a loan to value greater than 80% (meaning the borrower has at least put down 20%) if the borrower obtains private mortgage insurance to resolve the difference.  While the details of the plan have not come out yet (March 4 is the "detail date") it is pretty clear that the plan looks to get around the private mortgage insurance (PMI) issue.  From the Bloomberg article;

The proposal may violate requirements that homeowners put up at least 20 percent of the appraised value of a home or carry mortgage insurance, said U.S. Representative Scott Garrett of New Jersey, the ranking Republican on a panel that oversees the companies.  “I don’t see how that stands in face of what the statute says,” Garrett said in an interview. “It certainly seems as though they need to seek a congressional change, a legislative statutory change.”

The regulators have a plan to avoid this issue.  Here's chief GSE regulator James Lockhart;

Fannie and Freddie’s chief regulator, James Lockhart, has said the changes are exempted from mortgage-insurance rules written into the companies’ charters and won’t require new appraisals. Lockhart said the strategy will make it easier to help struggling homeowners get affordable mortgages.

Regulators will work around that requirement by treating the refinancings as a “modification for charter purposes,” not as new loans, Lockhart, director of the Federal Housing Finance Agency, said in a Feb. 20 letter to a mortgage insurance trade group.   

This is great!  Modification for charter purposes.  They say this because a modification is technically not a new loan.  Therefore, it gets around the charter issue of PMI for loans with LTVs greater than 80%.  However, there's a another problem!  Freddie and Fannie MBS have limits to how many loans can be modified in the pool.  This is there to protect bond holders who pay a premium for a bond and then lose that premium when the bond prepays.  Here's how we get around that;

“The new refinanced loan is treated as a new origination because the old loan is paid off,” said Amy Bonitatibus, a Fannie spokeswoman.

Ahh, so for modification restrictions in existing MBS we call it a refinancing!  Dizzy yet?  Additionally, Freddie and Fannie will not be requiring new appraisals!  Therefore, how will they know if a loan is greater than its new LTV limit of 105%?  They won't!! 

This is going to be a trial lawyers picnic!  Law suits will be flying from every direction.  I know the government is trying to do what they have to do to bring foreclosure relief.  However, shouldn't someone have nipped this in the bud and started working immediately (like back in November) to ready Congress to vote for a amendment to the GSE's charter rather than this ridiculous scheme!

Jeez...I'm telling you I could have done a better job with all this with a few friends, from my house, with all the beer we could drink!

Oh!  Foxnews Strategy Room today 9am-10:30am.  See you there!

Asia to Freddie and Fannie: "That's Nice Kids, Now Please Put Your Uncle Sam on the Phone."

I have to hand it to Asia, they are playing this one beautifully.  Story in Bloomberg today, "Fannie Mae Rescue Hindered as Asians Seek Guarantee."

Feb. 20 (Bloomberg) -- Asian investors won’t buy debt and mortgage-backed securities from Fannie Mae and Freddie Mac until they carry explicit U.S. guarantees, similar to those given on bonds issued by Bank of America Corp. or Citigroup Inc.  The risks are too great without a pledge that the U.S. will repay the debt no matter what, according to Hideo Shimomura, chief fund investor in Tokyo for Mitsubishi UFJ Asset Management Co., and other bondholders and analysts in Japan, China and South Korea interviewed by Bloomberg. Overseas resistance may hamper U.S. efforts to hold down home-loan rates and rebuild the nation’s largest mortgage-finance companies.

Even after President Barack Obamavowed on Feb. 18 to sink as much as $400 billion of capital into Fannie Mae and Freddie Mac, double the original commitment, “there is still a concern that there is no guarantee” from the government, said Shimomura, who oversees $4 billion in non-yen bonds for the arm of Japan’s largest bank.

“Looking at the risk, they’re not so attractive,” he said. “We need a guarantee before we’ll buy.”

The government has been trying like the dickens to avoid having to put the explicit full faith and credit guarantee behind Freddie and Fannie and now the jig is up.  The reason Treasury has been doing, as Gregory Hines would have called it, "The Ethiopian Shim-Sham" is because if the U.S. Government has to explicitly back $1.7 trillion of GSE debt (we haven't even talked about the FHLBs yet) as well as $3.7 trillion of mortgage backed securities we will more than double Treasury's current debt.  Now that Treasury and the Fed, using Freddie and Fannie, are looking to launch the mother of all refinancing waves, Asia is essentially saying, "We'll take the $billions that come to us at par when these securities prepay and put some to work in the markets Treasury or FDIC has extended the full faith and credit of Uncle Sam to, and the rest of the dollars....we'll cross that bridge when we get there."

Asia saying they are not going to play ball with regard to financing Freddie and Fannie, which they are going to need as they grow their retained portfolios, or by buying new, shiny Fannie and Freddie 4% MBS, means President Obama's big housing program has a big problem.  Asia declaring a buyers strike on new MBS purchases, just as we ready to make a few hundred billion new ones (talking gross supply here, net will be smaller because many "new" securities will be the result of refinance driven prepayments of older MBS) is going to put TREMENDOUS pressure on the MBS market and, all else equal, push mortgage rates in the wrong direction.....UP.  What that means is THE BUYER of all these new MBS will be the Federal Reserve and Treasury.  To drive mortgage rates lower they will have to buy at increasingly tighter and tighter levels.  That will end up in a situation technical that fixed income specialists call F.U.B.A.R.  The government will own at least $750 billion of these new MBS right around a price of 100-00.  History has shown us that just when the last forced purchase takes place, interest rates like the ten-year Treasury will go from 2.85% to 5.00%, moving the dollar price of those MBS to a price less than 80-00!  A twenty percent loss on $750 billion is a cool $150 billion.  Hi-ya!

I'd expect Treasury to extend the full faith and credit to GSE debt and MBS by early next week.

Good Lord I Love Frank Raines!

Man do I love former CEO of Fannie Mae Franklin Raines!  He is so deliciously arrogant, scrumptiously delusional and outrageously ballsy that if I had just followed him around for the last two years and blogged his statements and actions I could have a blog totally devoted to him.  "The Six-Degrees of Frank Raines Bull-sh*t!" or something to that effect!

Today, Raines stood before Congress, head held high and said;

"It is remarkable that during the period that Fannie Mae substantially increased its exposure to credit risk its regulator made no visible effort to enforce any limits.  The regulator limited its intervention to the size of the on-balance sheet mortgage portfolio and the attendant interest rate risk.  Indeed, right up until the time Fannie Mae was placed into conservatorship the director of OFHEO maintained that the company was in full compliance."

Now, I will give Raines credit that this is indeed true.  However, the man sitting right next to Raines, Dan Mudd, should have started squirming in his seat.  You see, Raines got the boot in late 2004 and Mudd took over.  Raines got the boot because on his watch, and at his direction, Fannie lost billions between the years of 2001-2004 through the incompetent management of its gigantic interest rate risk position.  They then committed accounting fraud to cover up the losses, in no small part, to help Raines and his pals in senior management get millions in bonuses.  Dan Mudd took over in 2005, which was remarkable considering he was on Raines' management team as Chief Operating Officer!  Mudd then helped lead Fannie down the path to the credit risk. 

Here is what I love about Raines.  He blames OFHEO, the underfunded undermanned regulatory agency for not properly engaging Fannie's foray into credit risk.  However, Frank Raines devoted a good part of his time at Fannie Mae greasing every politician he could get near to ensure that a real regulator was never created for Fannie and Freddie.  And to this end he succeeded brilliantly because one never was!  Additionally, between his accounting fraud and his cousin Freddie Mac's accounting fraud, OFHEO was already up to their undermanned eyeballs.  What I really love however, is if Fannie Mae was so concerned that the regulator was not picking up on the increased credit risk, did Fannie ever say to OFHEO, "Hey, we're losing market share and we really want to fulfill our housing mandate.  Therefore, we are going to move down the credit curve in a material way.  Are you guys ok with this increased risk profile?"  I'm going to say......no.

Anyway, keep it up Frank you crazy bastard.  You're just killing me!

Freddie Drops $25 Billion. The Number Should Have Been Closer to $35 Billion!

Freddie Mac announced a third-quarter loss of $25 Billion.  The company wrote its Tax Deferred Asset down by $14.3 billion.  It still has $11.9 billion of that asset on the books.  Why is Freddie still allowed to carry that asset at such a substantial value when Fannie essentially wrote theirs off?  Freddie has become a tool of Treasury to take in substandard loans and help in the modification process.  They have also been told to lower the cost of the new mortgage guarantees they write in order to lower primary mortgage rates.  Given the increase in risk profile and the decline in the potential premiums Freddie can charge on new business you think that they are going to make around $30 to $35 billion in net income over the next ten years?  If you think those numbers sound a little far fetched, which they are, then why does nearly $12 billion of this asset still count as capital?

Whatever.  Freddie and Fannie now stand naked against the losses to be generated against their mortgage insurance books.  Even if you include the $11.9 billion of tax deferred asset, Freddie has negative net worth of $13.7 billion.  Hence, they asked Treasury for its first capital injection.  We have dedicated $100 billion each for Freddie and Fannie.  Both companies say it may not be enough and it probably isn't.  Bummer for us.

Fannie Bids Farewell to a Classic Bit of Accounting Fiction!

It is a truly historic day today.  Fannie Mae will write down its $20.6 billion "Tax Deferred Asset" to ZERO.  We say goodbye to one of the greatest pieces of accounting fiction ever.  Somewhere, Enron CFO Andy Fastow is shedding a tear.  This "asset" sat completely unreserved on Fannie's books and accounted for HALF their capital for at least a year!  A tax deferred asset is nothing more than losses capitalized on the balance sheet that can be used against future income.  Unless Fannie planned on making about $80 billion over the next decade, it should have been impossible for Fannie to carry this asset completely unreserved.  Did anyone expect Fannie or Freddie (they have a huge, unreserved tax deferred asset too) to post $multi billion profits over the next few years?  I think not.

This piece of accounting fraud was "hidden in plain sight" for over a year, a year where both companies, their accountants and their regulator assured us that both Freddie and Fannie were solvent.  It was ludicrous and insulting to anyone's intelligence.  Finally, when the stench was just completely overwhelming, Hank Paulson and Treasury pulled the plug. 

Farewell Tax Deferred Asset, it was one hell of a run!

Government Using All Its NEW Assets!

Bloomberg News is reporting that The Federal Housing Finance Agency (FHFA) is ordering Freddie Mac and Fannie Mae to start purchasing $40 billion ($20 billion each) of "under-performing" loans a month.  Presumably, these loans will then be modified and reset to reflect a 90% Loan to Value of the borrowers home.  The good news is the Treasury is using Freddie and Fannie to mitigate foreclosures by modifying loans.  I am assuming that, unlike "TARP", the institutions that sell the subprime and Alt-A loans to Freddie and Fannie are not subject to things like giving Treasury equity shares or implementing executive compensation caps like they would be if they "volunteered" to engage with the Treasury under TARP.  There's a nice loophole that I hope they close, at least lets get some equity.  I expect banks to be climbing over one another to unload into this program.

The bad news is that $200 billion that Congress granted Treasury to inject into Freddie and Fannie will get used up pretty quickly.  Between the new asset purchases and Freddie and Fannie's losses from it's existing book of business, the full $200 billion of capital may have to be injected.  That doesn't mean it's gone, it's just not in our hands anymore.  It is important to remember that this $200 billion is separate from the $700 billion.  I think these are necessary steps to get directly at the point of the problem in our housing markets.  It's hard to say it, but I believe it's the right thing to do.

The Government Has Solved Freddie & Fannie Capital Problems: They Won't Report Them Anymore!

The Federal Housing and Finance Agency (FHFA) revised Freddie and Fannie's capital calculation and classification to "undercapitalized" in the second quarter.  This should not come as a shock but rather an illustration of why the two GSEs needed to be taken into conservatorship.

The funny part of this story is the FHFA has decided it would be in everyone's best interest if they just stopped reporting the two companies capital classification altogether!  Here is the quote from the FHFA;

     ``The director has determined that it is prudent and in the best interests of the market to suspend capital classifications,'' FHFA said.

You really can't make this stuff up.  You really can't!

Hank & Ben Say "We Need it TODAY!" Congress Pushes Back..At 6pm Goldman Sachs Gets $5 Billion From Buffett! Now I'm Really Scared!!

It takes a lot to shock me these days.  Yesterday I watched Hank Paulson and Ben Bernanke come up to Capital Hill armed with a two to three page proposal to spend $700 billion on the "Troubled Asset Relief Act".  They told Congress that they planned on paying something that Bernanke called, "Held to Maturity Value", and I started getting real nervous.  Senators pushed back on Hank and Ben and maybe for the first time since I was eight, I was on the side of the Senators!  Chairman Bernanke and Secretary Paulson see the tidal wave coming.  It is a tidal wave that some of us have seen for some time now.  I think that in the first week of September, Paulson and Bernanke finally saw what we saw.  The defaults and losses in residential mortgages were just in first-gear.  A whole bunch of subprime, Atl-A, and Alt-A Option ARMS are going to reset over the next twelve months and hundreds of billions of mortgages are going to default at a time when Loan to Value ratios where soaring to 120-130%.  Here is something we wrote back on September 7, 2008.  It was titled "Freddie & Fannie Bailout: Why Now and Why You Should Be Scared"

Today, the Government of the United States took over Fannie Mae and Freddie Mac.  It was a move that Treasury Secretary Henry Paulson and The White House desperately did NOT want to make on their watch.  Hence, all the talk about bazookas in pockets.  As most have predicted, Treasury now will begin a series of preferred stock purchase agreements, adding capital to Freddie and Fannie as needed.  Each time Treasury buys in, existing common and preferred share holders get pushed further and further down the capital structure until the losses Freddie and Fannie will take consume them.  It sounds right out of an "Animal Planet" documentary.  Dick Syron and Dan Mudd can now leave to "pursue other interests" or "spend more time with family."

What you might be asking is, "Why now?"  After all, Paulson has been talking right up until the middle of last week that he's confident he won't have to use his Treasury preferred purchase powers (the bazooka).  What changed his mind so suddenly?  Paulson is claiming that based on discussions with his advisors at Morgan Stanley (I still laugh every time I think about Paulson bringing them in as "advisors") he now sees that both Freddie and Fannie are essentially insolvent.  I'm not sure why he needed Morgan Stanley to tell him that.  After all, It's not rocket science or fifty little line-items that may or may not add up to insolvency.  It's the "Tax Deferred Asset" and the "Temporary Loss on Securities" entries. The Tax Deferred Asset alone is $35 billion for the combined entities!  The Temporary-Loss item is at least $20 billion.  I'm assuming Paulson took a couple of accounting courses when he attended The Harvard Business School.  He really didn't need an advisor to tell him these guys were cooked. 

Here's what scares the crap out of me;

1. The Mortgage Bankers of America put out their monthly delinquency and foreclosure data on Friday.  Serious delinquencies (90 days or greater) and foreclosures on BOTH PRIME AND SUBPRIME continue to increase unabated.  With the rise in unemployment, continued deterioration of real estate prices, and the specter of billions of negatively amortizing option ARMs hitting their principal caps, (thus driving more mortgagees into default), the housing situation is getting worse at an increasing rate.
2. Former Federal Reserve Chairman Paul Volcker said on Friday, "This bright new system, this practice  in the United States, this practice in the United Kingdom and elsewhere has broken down.  Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.  It is the most complicated financial crisis I have ever experienced and I have experienced a few."
3. Finally, Secretary Paulson, a man who seems to increase the frequency of his "all is well" speeches right when we are on the brink of something really bad, said in his statement today, "Nothing about our actions today in any way reflects a changed view of the housing correction or the strength of other U.S. financial institutions."

I don't know about you, but if numbers one and two didn't get you, number three has to clinch it!  Stock up on the bottled water, canned foods and ammo because things are about to get a whole lot worse.

Bernanke and Paulson have got religion now and they are trying to say it in any way possible without having to just come out and say it.  They need that $700 billion to get the assets that are going to take catastrophic hits off the bank books and on to our "non-public" books.  We know this because if Paulson and Bernanke truly believed that market prices are purely based on fear and illiquidity and that many of these assets are going to return their original cost (some combination of principal and interest), they would just wave the mark to market accounting on these assets and let institutions hold them at cost.  In some cases, this would allow for write-ups.  You might be saying, "Eric, that's stupid.  Do you know how difficult and damaging it would be to get everyone on board with that type of accounting methodology change?"  My answer would be, "Is it harder than raising $700 billion to buy these assets at cost from the banks and convince tax-payers that it has to be done?"  The government knows that if it just lets banks carry these assets at cost, the defaults and losses coming will force them to take huge writedowns as the assets become impaired.  If they are on "OUR" books, who is going to notice?

Finally, after Congress pushed back hard yesterday and most probably today, Goldman Sachs raises $5 billion of perpetual preferred from Warren Buffett, with a 10% coupon, and gives him $5 billion of five-year warrants to buy more Goldman shares at $115 (GS closed at $125 yesterday) at 6PM!  Goldman also plans to raise $2.5 billion of common stock.  Morgan Stanley and even Goldman Sachs found themselves staring into the abyss last Thursday as a run on money market mutual funds intensified.  Hence, the bank charters and the capital raises.  Do you think Goldman makes a sweet, sweet deal with Buffett yesterday if Congress just rolled over and gave Hank and Ben their $700 billion?  I don't think so.  The Buffett deal was,  in my opinion, Plan B.

Hang on to your hats.

**AND JUST NOW Goldman has doubled the $2.5 billion of Common Stock they were raising to $5 billion!

Senators Ask Fannie & Freddie to Freeze Foreclosures.

Bloomberg News is reporting that the Senate Banking Committee is urging Freddie and Fannie to freeze foreclosures on loans in their portfolios for at least ninety days.  In a letter from the committee to the Federal Housing Finance Agency said,

"This action would provide immediate relief to many homeowners and let the companies turn these non-performing loans into performing assets to minimize losses."

This is great!  They are asking the two companies that just got nationalized and had their stock value reduced to pennies whether they can give some room in their risk book and to keep carrying the loans on the balance sheet at loss.  What are the GSEs going to say?  My bet is;

"Sure dudes, whatever.  After all it's your money, freeze the whole damn book for 180 days if you like.  We're going to lunch, see you tomorrow..or maybe Monday....afternoon!"

The GSE Bailout: Who it Helps and Who it Doesn't.

The U.S. Government's bailout of Freddie Mac and Fannie Mae produced yesterday what one of our friends who trades mortgage backed securities called, "An epic day".  It was also quite an epic day for financial stocks, lifting almost all boats except for poor Lehman Brothers and Wamu.  I turned on CNBC a few times yesterday afternoon, and listened to money managers gushing about how they were long financial stocks (no one seemed to fess up that they were long Freddie or Fannie) and were going to buy on any weakness.  The main reason they gave was that the GSE bailout had put a "floor" under bank stock prices, re-introduced liquidity into mortgage finance, and stabilized the housing market.  Interestingly, home-builders put in solid 10% gains yesterday off of the news.  With all this dramatic price action I thought it would be a good idea to think through and identify who or what the bailout helps and who or what it doesn't.  Here we go;

1. Spreads to treasury on prime conforming mortgage loans and mortgage backed securities (Freddie and Fannie MBS) are absolutely helped.  This one, for at least the remainder of the year, is a no-brainer.  Before Sunday, these spreads were at historically wide levels as investors grappled with all sorts of very important questions.  No one knew if Freddie and Fannie were going to be allowed to keep purchasing mortgages for their retained portfolios.  Additionally, no one knew if the GSEs were going to be ordered to start reducing the size of the portfolios, and if so, when and by how much.  Like we said in an earlier post, this vital investment sector was filled with many "Who knows?"  "Who knows" is usually a very bad technical for any market.  Now we know that the GSEs can increase their portfolios by approximately $144 billion from now till year-end 2009.  Treasury can also buy MBS when they feel necessary.  The question now is, will the GSEs buy mortgages based on much lower Return on Equity parameters than in  the past?  This is the type of "Who knows" that is actually good for prime mortgage spreads.  After all if you're Joe Hedgefund are you going to get short MBS versus Treasuries when Uncle Sam can create a gigantic short squeeze because they feel like it?  Probably not.  Smart guys will be trading MBS either neutral or from the long-side.
2. Tighter conventional mortgage spreads to risk-free (treasury) rates certainly don't hurt housing but how much do they help?  All else equal, if on Friday your mortgage lender quoted you a rate on a thirty-year fixed rate mortgage of 6.75%, now its probably 6.375%.  That's good.  However, in the current real estate market, does cheaper financing trump awful supply and demand technicals?  I'm going to say, not by much.  With supply growing every day with foreclosed properties hitting the market and home builders desperate to reduce inventory, does a mortgage rate half a percent lower get most people who can actually afford to invest in a home off the sidelines?  I don't think so.  Housing deflation has firmly taken hold of our psyche.  Why buy now when its going to be worth 10% or less in six-months?  Let's take a home that's for sale for $400,000.  If you were going to buy that house, with the prospect of losing $40,000 in a year, the difference of half a percent on a $320,000 mortgage monthly payment is $104.  At that rate it would take you way over thirty years to make up the difference!  So overall, the bailout doesn't help too much.  I will say though that it will bring the normally superior liquidity back to the Freddie/Fannie MBS market and that will make it easier for originators to make loans to you..  So that's a positive.
3. Yesterday, I heard a money-manager who was long financial stocks say that improving liquidity to Freddie/Fannie MBS will flow to other, less liquid mortgage products.  If I was sitting in a chair I would have fallen out of it!  Agency MBS usually trade (bid/offer) about 1/64 of a percent.  As things got hairy, they have traded as wide as 1/8 of a percent.  It is the most liquid fixed-income market in the world.  Thinking that there is going to be follow through to ANY other sector that represents problem mortgage assets for banks and other financials is ridiculous.  Back in 2006, the hey-day for structured mortgage product, when The Street was pretending there was a liquid secondary market for this stuff (liquidity in the secondary market was a loss leader for the new issuance business) the bid/offer spread was multiple percentage points!  Now? Ten points, fifteen points? Probably.  The Alt-A option arm mezzanine securities banks are choking on are not effected by this at all.  If John Thain at Merrill was able to sell his $30.6 billion CDO position to Lone Star TODAY versus a  MONTH ago, he would have gotten the same crappy bid.  The bailout does nothing to help banks move their illiquid mortgage investments.
4. Does the bailout help delinquent or defaulting borrowers?  The very simple answer is no.  That is going to take another move by the government which right now is governed under their Housing Recovery Act of 2008. Hence, the supply of foreclosed homes hitting the market market.
5. Does the bailout help free up bank balance sheets and expand credit?  On the margin it helps a little bit with regard to banks being able to sell prime conforming loans into the secondary Agency MBS market.  However, bank balance sheets are still way too big given both their existing capital and future, lower capital positions as credit hits keep coming.  We have seen that the inter-bank term funding market still do not function without central bank intervention.  I don't see this situation improving.  Unfortunately, as we get to year-end, it will get worse.
6. Does the bailout provide any sort of a kick start to the economy?  Yes, I think the GSEs ability to expand their retained portfolios and thus lowering mortgage rate, all else equal can make it easier to refinance existing conventional/conforming loans and put money in people's pockets.  However, the sharp decline in real-estate prices is going to impede many borrowers from refinancing as their existing loan may equal or exceed 100% of their home value.  Therefore, much of the refinancing that gets done will not allow the borrower to take out more cash.  This is called a cash-out refinancing.  Hence, the next refinancing event will be much less effective in jump starting consumer spending.  Additionally, while the bailout helps mortgage rate spreads, there is a good chance it increases absolute rates as the U.S. Treasury notes that mortgage rates are tied to may increase substantially as our budget deficit swells.
7. Finally, because I am tired, does the bailout help any of the banks other business lines that are faltering?  Commercial Mortgage Backed Securities, High Yield Loans, Credit Cards, Auto Loans?  Not at all.  The banks have yet to post the full brunt of the CMBS and High Yield Loan losses that are surely coming.  Additionally, as the economy and employment environment weakens, consumer credit businesses will be posting huge losses for the foreseeable future.

Therefore, I think this bailout on its own will do very little for financial and home builder stock valuations.  I also think that much of the "systemic risk" alleviation was already priced in back in July when Treasury first got the permission to take the GSEs into conservatorship.  If I were you I'd be selling the financials.  Watching TV yesterday, it seems we have lots of people ready to take the other side of the trade.  Bless them.

Paulson to Syron and Mudd: "Don't Worry Everybody Gets a Trophy."

Another triple category special!  This time we have "Bullsh*t", "Comedy" and "Fannie & Freddie".  Hank Paulson wants to make sure that everyone knows that none of this fiasco was Freddie and Fannie senior management's fault.  Here is what Paulson said in his statement yesterday, and repeated today;

"I appreciate the productive cooperation we have received from the boards and the management of both GSEs.  I attribute the need for today's action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction.  GSE managements and their Boards are responsible for neither"

I am sure that part of the negotiations that Syron and Mudd had with Treasury to "invite" them to take the GSEs into conservatorship included Paulson making a ridiculous statement like this.  However, what a freaking insult to just about ANYBODY'S intelligence!  We know for a fact that Mudd and especially Syron played the "flawed" business model to the tune of $30 million in compensation last year.  They took excessive risk by moving further down the residential mortgage credit curve to make shareholders happy and get themselves paid.  That is it, end of story.  You know what else is really funny.  The only reason Fannie didn't get involved as much as Freddie did in non-prime credit is because in 2005-2006, Fannie was going through their financial report restatement process after their little accounting fraud issue!  They couldn't devote the resources to mortgage credit.  Always better to be lucky than smart, and in this case, lucky and stupid.

If Freddie and Fannie were just two little boats that had no control over how much money they made, or lost, but rather, were just subject to the ebbs and flows of the housing market then why the hell did Dick Syron get paid $38 million from 2004 to 2007?  There's a lot of other executives at both these companies that got paid an awful lot too.  Check out what Chief Investment Officer Patti Cook took out the last three years.  What a freaking joke.  If Senator Chris Dodd wants to have a hearing, have a hearing about that.

This seems to be the way it goes these days, just like little league.  We're all winners, no one is a loser. It's nobody's fault and everyone gets a trophy.  Execpt us.

Senator Chris Dodd to Hold Hearings on Freddie & Fannie Takeover!

This will be a short but memorable post.  For the first time since writing this blog we have a triple category header!  This one will go into "Bullsh*t", "Stupid Politician Tricks" and "Freddie & Fannie"!

Senator Chris Dodd wants to hold hearings on Treasury's move to take Freddie and Fannie into conservatorship.  Here's a quote from Senator Dodd;

Why weren't we doing more, why did we wait almost a year before there were any significant steps taken to try to deal with this problem?  I have a lot of questions about where was the administration over the last eight years."

Right now about two hundred and ninety of his fellow Democratic congressmen just shat their pants!  First of all, I really try not to be political on this blog.  That being said, if you added up the lobbying dollars that Freddie and Fannie allocated to our elected officials over the last two decades, I think the Democrats got more than fifty percent of the $MILLIONS.  Just ask former Fannie CEOs Jim Johnson and Frank Raines!  If I were Dick Syron or Dan Mudd and I wanted to do one big F-You before I went home I would answer Senator Dodd with this;

"Hey Mr Chairman of the Senate Banking Committee, you want to know why no one did anything the last eight years?  Here's a list of congressmen and the amounts that they or their special projects got from Freddie and Fannie (including the foundations) over the last twenty years.  Hey I think you're on here too!"

Freddie/Fannie Bailout: Why Now and Why You Should be Scared.

Today, the Government of the United States took over Fannie Mae and Freddie Mac.  It was a move that Treasury Secretary Henry Paulson and The White House desperately did NOT want to make on their watch.  Hence, all the talk about bazookas in pockets.  As most have predicted, Treasury now will begin a series of preferred stock purchase agreements, adding capital to Freddie and Fannie as needed.  Each time Treasury buys in, existing common and preferred share holders get pushed further and further down the capital structure until the losses Freddie and Fannie will take consume them.  It sounds right out of an "Animal Planet" documentary.  Dick Syron and Dan Mudd can now leave to "pursue other interests" or "spend more time with family."

What you might be asking is, "Why now?"  After all, Paulson has been talking right up until the middle of last week that he's confident he won't have to use his Treasury preferred purchase powers (the bazooka).  What changed his mind so suddenly?  Paulson is claiming that based on discussions with his advisors at Morgan Stanley (I still laugh every time I think about Paulson bringing them in as "advisors") he now sees that both Freddie and Fannie are essentially insolvent.  I'm not sure why he needed Morgan Stanley to tell him that.  After all, It's not rocket science or fifty little line-items that may or may not add up to insolvency.  It's the "Tax Deferred Asset" and the "Temporary Loss on Securities" entries. The Tax Deferred Asset alone is $35 billion for the combined entities!  The Temporary-Loss item is at least $20 billion.  I'm assuming Paulson took a couple of accounting courses when he attended The Harvard Business School.  He really didn't need an advisor to tell him these guys were cooked. 

Here's what scares the crap out of me;

1. The Mortgage Bankers of America put out their monthly delinquency and foreclosure data on Friday.  Serious delinquencies (90 days or greater) and foreclosures on BOTH PRIME AND SUBPRIME continue to increase unabated.  With the rise in unemployment, continued deterioration of real estate prices, and the specter of billions of negatively amortizing option ARMs hitting their principal caps, (thus driving more mortgagees into default), the housing situation is getting worse at an increasing rate.
2. Former Federal Reserve Chairman Paul Volcker said on Friday, "This bright new system, this practice  in the United States, this practice in the United Kingdom and elsewhere has broken down.  Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation.  It is the most complicated financial crisis I have ever experienced and I have experienced a few."
3. Finally, Secretary Paulson, a man who seems to increase the frequency of his "all is well" speeches right when we are on the brink of something really bad, said in his statement today, "Nothing about our actions today in any way reflects a changed view of the housing correction or the strength of other U.S. financial institutions."

I don't know about you, but if numbers one and two didn't get you, number three has to clinch it!  Stock up on the bottled water, canned foods and ammo because things are about to get a whole lot worse. 

If you noticed, Treasury is going to let Freddie and Fannie continue to buy mortgages for their retained portfolios, up to a $850 billion cap for each (or $1.7 trillion) from now till the end of 2009.  As of July, the combined retained portfolios of the two entities was approximately $1.55 trillion, so a net allowable increase of 9.7%.  That's some pretty broad buying power.  Remember, the portfolios have monthly run off of about 2%.  Why give them that strong buying power?  Because the government, through Freddie and Fannie's bid, needs to inject a lot of capital into the mortgage market to try to bring mortgage rates down to improve housing technicals and spark a little refinancing wave to put some additional cash into our pockets.  The only way they can let Fannie and Freddie grow the retained portfolio is to put more capital into them.  Hence, we have what he had today, conservatorship with the Treasury standing by to pump capital into Freddie and Fannie.

All this tells me that the outlook for the future is very grim.  This Treasury Department did NOT want to do this NOW and I don't buy the stories that the Chinese threatened to walk away from the debt auctions.  That was just a smart bluff on their part to get better yields.  Paulson sees a category five storm just off shore and we can't wait until January 2009 to do something.  Think about that when the talking heads on the TV try to get you to  look at this as a positive sign to buy financials over the next few days.  Don't get suckered.

 

Freddie and Fannie's Capital Calculation Bogus?? NO! REALLY??

As I read the newspapers this morning about what drove Hank Paulson to take Freddie and Fannie into conservatorship I wish I was outraged.  I wish I was outraged by the fact that it took Morgan Stanley's analysis of Freddie and Fannie's accounting hijinx to finally get someone with authority to take action.  However, I am not outraged because it's just so typical.  Jon Weil from Bloomberg News has been illustrating how Freddie and Fannie are insolvent under GAAP for at least the last eight months.  We've been reading Jon and really just reporting as loud as we can that this whole thing is a dangerous and costly charade. 

This has been a costly joke since Treasury got the permission to go into Freddie and Fannie in July.  Debt investors have been playing Treasury beautifully.  Once Hank Paulson announced he had a bazooka in his pocket they knew they were buying risk free debt at distressed prices.  They've been loading up on inflated yields with the full knowledge that once the inevitable happened, GSE senior debt would snap in faster than a new bra strap.  Everyone is yelling at Bill Gross for talking his position last week (telling Treasury to take over), but I think he was giving the correct advice.  Don't blame him for making money by seeing this move coming.  It was as obvious as the nose on my face, and I got a big nose!  I wonder how many $ millions we've wasted in the last month raising billions of new GSE debt at "distressed" levels.  I'm going to venture it may be near a $ billion.

Anyway, we'll have more on the story once Hank comes out with the plan later today.  Here is a repost of a piece we wrote July 29, "Fannie and Freddie Continue to Make Enron Look Downright Righteous!"

As I sit here awaiting  S&PCase/Shiller home value numbers I am reading a very interesting article from Bloomberg's Jon Weil titled, "Freddie, Fannie 'Fair Values' Hardly Look Fair".  I figure after another disastrous round of housing numbers (coming in about 10 minutes) we should all take another look under the skirts of the two GSEs we, the U.S. tax-payers, will soon be owning.  Might as well right?

This is how Mr. Weil starts the article, "Forget everything you've read about how woefully under-capitalized Fannie Mae and Freddie Mac are.  The situation is much worse."  Nice!  Mr. Weil points out that the inclusion of "Tax Deferred Assets" into "core capital" dramatically overstates the companies capital positions.  Even worse, when Fannie and Freddie calculate their fair-value balance sheets once a quarter (they do this to show the "true" value of the companies balance sheet) they MARK UP the Tax Deferred Assets! 

As Mr. Weil states with regard to Tax Deferred Assets, "Commercial banks, by comparison, normally don't get to count these in their capital because they can't be sold by themselves and, thus, can't be used as a cushion against losses."  That's pretty comforting no?  Furthermore, just like he pointed out with regard to MBIA and Ambac, these Tax Deferred Assets (which are nothing more than deferred losses) have a valuation allowance of ZERO against them.  The only way that these assets can be carried without a valuation adjustment is if the companies both believe they will make many $10's of billions of net income over the next few years.  Somehow I don't see that as a 100% certain  outcome.  They should at least put an allowance of SOMETHING to reflect that things aren't looking too good for them right now.  As of their last financial statements, March 31, 2008, Fannie Mae has a $17.8 billion Tax Deferred Asset and Freddie has a $16.6 billion Tax Deferred Asset.  Fannie and Freddie have reported core capital surpluses of $5.1 billion and $6 billion respectively.  Take away half of those Tax Deferred Assets and their ain't no more surplus.  Also, remember that this capital calculation lets them keeps billions of losses on their securities portfolio in suspended animation (Temporary Loss Valuations) and, thus, not included in the core capital calculation.

But wait, it gets better!  This is where I think Andrew Fastow from Enron has to be giving Fannie and Freddie, "Mad Respect"!  When the GSE's calculate their fair-value balance sheet (the one that shows Freddie insolvent by $5.2 billion) they MARK UP the Tax Deferred Asset by approximately $14.3 billion and $10.1 billion respectively!  Mr. Weil says that, "The way this works is the company calculates the tax effects on the difference between its shareholder equity at fair value and under GAAP; it then includes these in other assets."  Holy crap!! Why go through the bother of producing accounting statements?  Why can't their just be a cell in a Excel spreadsheet that just plugs the difference between the capital they are supposed to have and what they actually have and call it done!  They should do the same thing for the Fair-Value Statement!  Anyway, if you remove this "adjustment" Fannie's fair value as of March 31, 2008 would be negative $2.1 billion.  Freddie's fair value would be negative $15.3 billion!

Somewhere, Kenny Lay is smiling.

Freddie & Fannie Equity Analysts Prove P.T. Barnum Correct. There IS a Sucker Born Every Minute.

I'm on vacation this week and I'm trying to relax.  However when I see stories like this on Bloomberg News I get pissed off.  Check this out;

Aug. 27 (Bloomberg) -- Fannie Mae and Freddie Mac rose in New York stock trading after successful debt sales and a Merrill Lynch & Co. analyst report helped to suppress speculation that the companies have an imminent need for a government bailout.

``It is still premature to consider a Treasury sponsored recapitalization, in our view, as capital depletion would not likely occur for several quarters on our estimates,'' Merrill analysts Kenneth Bruce and Cyrus Lowe in San Francisco wrote in a report today. ``This suggests that the shares are overly- discounting a possible catastrophic event.''

Lets deal with the first reason given for the current run up in GSE stock prices.  Freddie and Fannie were both able to conduct "successful" funding operations, albeit at relatively very wide spreads.  Why do you think both companies are able to "successfully tap the funding markets"?  Because in the minds of senior debt investors the freaking bailout has already occurred!  What part of this do equity investors not understand?  The senior debt holders are buying what they consider to be risk free debt at a fat spread to the risk free Treasury rate.  If Hank Paulson sneezed funny and it even remotely sounded like he said "No Bailout" in ANY LANGUAGE, the entire financial system would see a collapse of biblical proportions within twenty four hours!  Therefore, if you are an equity holder and the bailout has for all intents and purposes occurred, your dead.  If you are holding Freddie and some dope shows you a $4.50 bid, size him and tattoo him!

With regard to the Merrill analysts assertion that Freddie and Fannie are generating income and could put off a bailout for a few quarters, WHO CARES!  We know that they are generating great business right now.  However, have you been paying attention to the housing numbers the last couple of days?  They get worse every day.  I am sorry to say that the losses Freddie and Fannie have coming in their books overwhelms any numbers these firms can put up over the next six to nine months.  If the actual bailout is prolonged, it is probably going to be prolonged for political purposes.  George Bush would much rather give President Obama or President McCain the honor of writing that first check.  In any event, if your a common equity investor, what does it matter to you whether the event occurs tomorrow or next January?  The bailout is already a certainty.  If it wasn't these debt auctions wouldn't be going so well.  Please, for heaven sake, don't buy these companies unless you are covering a profitable short, and even then, don't buy them!

Freddie and Fannie Debt Investors Ask to See Hank Paulson's Bazooka

Back in late July when "The Housing and Economic Recovery Act of 2008" was signed into law, giving the U.S. Treasury permission to purchase unlimited stakes in Freddie Mac and Fannie Mae, Treasury Secretary Henry Paulson said the following, "If people know you have a bazooka, they won't make you use it."  What he meant was, now that the world knew he had the power to effectively make the U.S. Government guarantee of Freddie and Fannie EXPLICIT, it would be enough to restore confidence amongst senior debt holders and holders of the mortgage backed securities guaranteed by the GSEs.  It hasn't.

On Monday, Freddie Mac sold $3 billion of five-year senior debt at a spread of 1.13% over the risk-free five-year Treasury note.  Asian institutional participation was only 30%, down from 41% in the May five-year auction.  The spread in the May auction was .69%.  The debt investors aren't stupid.  I'm sure they fully believe that Freddie and Fannie debt is now fully guaranteed by Treasury.  However, until that guarantee truly becomes explicit with a injection of capital from Treasury, they hold all the cards.  They can pretend that they are worried and back bid all they want.  I could just imagine what was going on over last weekend as Freddie and the Wall Street syndicate managers fretted and prayed that the auction would go off "smoothly".  The debt investors, especially the Asian ones, know they are the hottest girl at the dance.  The can play coy and act like they might just sit this dance out.  And look what happened, they just bought U.S. Government guaranteed debt 1.13% over similar Treasury debt.  Bully for them and woe is to us.  That costs Freddie (soon to be "us") about $190 million.

Freddie and Fannie have $223 billion more debt rolling between now and the end of September.  It's time for Hank to take out the bazooka and put this issue to bed before we end up paying $ billions more in interest payments.  If you were the debt buyers, wouldn't you gleefully keep playing this little game until you couldn't anymore?  I know I would.  Hank Paulson has to do one of two things.  Either step up and twist the GSEs arms behind their back and make them "invite" Treasury to invest, or show the exhaustive analysis that Treasury must have done to show Paulson that both  GSEs were solvent and viable, therefore, not needing government capital.  Do you think that analysis exists?  Somehow, I doubt it.  If something like that, something that wouldn't make the most cynical accountant laugh his ass off existed, we would have seen it so many times that we would be sick of it.  It's time to end the charade.

Meanwhile, we have mortgage rates going higher and higher because Freddie and Fannie mortgage backed securities ("MBS") are experiencing the same difficulties, plus another big one.  If Freddie and Fannie get taken over, what will the future of the secondary mortgage market be? 

• Are they still going to make Freddie and Fannie MBS?
• Are they going to merge the two GSE and just make Fannies (this will have lots of profit and loss implications for holders of Freddie MBS)?
• If they decide to stop making Freddie and Fannie MBS, what's the alternative?

All these questions need to be answered, and issued in a clear, rational, unified and confident voice.  Until then we have, "Who knows?".  I can assure you one thing, "Who knows?" is not good "technical" for any market.  Unfortunately, this market is the one that essentially sets our mortgage rates and its going in the wrong direction.

One last thing before I exhort Hank to show his bazooka (heh-heh...heh-heh), according the the Housing Rescue legislation, Freddie and Fannie have to ASK Treasury to come in.  That's a good one!  It essentially means that Dick Syron and Dan Mudd have to call over to Treasury and ask to be fired!  You think they are going to do that on their own?  For two guys who had the gall to take down $30 million last year, when they knew that the future wasn't going to be "stellar", you think they'll do the right thing?  I doubt it.  They are like a ball-player with a "no-trade clause" who is killing the team with his play and his fat guaranteed contract.  I suggest Hank Paulson call a smart sports general manager like the Red Sox's Theo Epstein and ask how he got rid of Manny Ramirez!

..So Dick Syron and Dan Mudd Walk Into a Bar.....

So one nice summer day, Dan Mudd decided to go for a walk.  While on his very nice stroll he came to the bank of the Potomac River, Dan saw Dick Syron on the other side.  Dan called to Dick, "Yoo-hooo Dick, how do I get to the other side?"  Dick called back to Dan, "You ARE on the OTHER side!"

Dan Mudd and Dick Syron are sitting on a park bench in the evening and a full moon is out.  Dan turns to Dick and says, "Dick, which do you think is further away, Florida or the moon?"  Dick says, "HELOOOOOOOOOOO, can you SEE Florida? ...duh!"

Hank Paulson goes to the doctor because wherever he touches his body, he is in excruciating pain.  He doesn't want the doctor to know its him so he puts on a disguise.  Hank walks into the doctors office and says, "My body hurts everywhere I touch it."  The doctor says, "Impossible, show me."  So Hank touches his elbow "OW", he touches his knee, "OWW!!", he touches his chin, "OWWWW".  The doctor says, "Stop, you're Hank Paulson aren't you?"  Hank says, "Yes, I am."  The doctor says, "I thought so, your finger is broken."

While Hank Paulson Plays a Horrific Game of Poker, Fannie & Freddie Uncertainty Causes Real Damage

A long time ago I had always assumed that guys who rose to the top chair at big banks must be great poker players.  I just figured that fellows like these were good strategic thinkers with an eye toward detail and a keen knowledge of their opponents (both internal and external) strengths and weaknesses.  I imagined that one of their greatest strengths was the ability to bluff successfully.  I have been disabused of this notion over the last year and a half.  These guys, including Treasury Secretary Hank Paulson, are just horrible players. 

If we go back to March and April of 2007 and equate things to a poker game, we essentially had Stan O'Neal, Dick Fuld, John Mack, Chuck Prince, Angelo Mozilo, Jimmy Cayne and a host of others all take turns bluffing the hell out of a good majority of the investment community.  All these guys were showing cards that had them beat on the table.  However, because they so confidently bluffed us with claims that losses were insignificant and everything was hedged, investors said to themselves, "Well, he does have three clubs showing, he saw me and raised me double, he must have two clubs in his hand for a flush, I'm out."  However, after the third of fourth time of bluffing, investors called them and they folded.  It has become common knowledge now that when any of these guys (on your player roster now playing for O'Neal is John Thain, while playing for Chuck Prince is Vikram Pandit) says they have enough capital, or things are turning the corner, they are bluffing.  We therefore, call them and low and behold, they don't even have a low pair!

Lets turn to Hank Paulson, former chief of Goldman Sachs and now Treasury Secretary.  He has played a huge bluff with the Fannie Mae, Freddie Mac bailout.  Paulson made the dramatic move of asking for and receiving the authority to essentially nationalize Fannie and Freddie.  However, after receiving such authority he, along with other Treasury officials and The White House, have repeatedly stated that they have no intention of having to actually do the deed.  This move worked for a few weeks because frankly, there's just a lot of investors out there that either aren't doing their homework, or just don't get it.  Both Fannie Mae and Freddie Mac are, after you adjust for accounting shenanigans like unreserved tax deferred assets (not reserving against them AND for fair value purposes, actually marking the tax deferred assets UP) and their "temporary losses" in their securities portfolios, insolvent on a GAAP basis and a "Fair Value" basis.  That is a fact.  It is also a fact that both companies have just a sliver of capital against a $3.6 trillion mortgage insurance book that only needs to take about 1.5% actual losses (and they are coming) to wipe out Fannie and Freddie.  It's arithmetic.  You can't argue that 2+2= 5.

So now here we are, after Freddie and Fannie's disastrous second quarter earnings, with Hank Paulson at the table showing not even a pair or a decent flush or straight possibility and he's still trying to bluff us.  It's not working anymore.  In fact it is starting to have a very detrimental effect on housing finance.  Spreads on Fannie and Freddie mortgage backed securities are blowing out to record levels.  Because the secondary market yield for these securities determine the rates mortgage originators charge you on a mortgage loan, this is making the already horrific housing technicals worse.  These spreads are reflecting credit risk due to Paulson's bad bluff.  More importantly, these spreads are moving out because everyone that invests in Freddie and Fannie MBS needs to know what the plan is for this multi-$trillion market once Treasury steps in.  Questions like,

• Will they eventually stop making new Freddie and Fannie MBS (thats a good short term technical, but a real bad long term technical)? 
• If they do stop, what will replace them?  Will anything replace them? 

This very harmful uncertainty has come about because Treasury and Congress and The White House have spent precious time bluffing and praying.  We need a plan for the future of housing finance and a "Covered-Bond" photo-op with Paulson and a few bank chiefs doesn't cut it.  I proposed a solution on this blog "What to do with Fannie and Freddie".  Treasury's bluff has been called and its time for it to fold it's crappy hand and take charge.

One More Time, With Feeling!: What to Do With Fannie & Freddie?

Alright Out There, It Took Me Half a Sunday and a Twelve Pack of Bud Light to Write This and I Want Feedback!!  I put this out there Monday and got nada.  This is important stuff.  If my plan is stupid, tell me.  Give me alternatives.  Lets shoot ideas around and try to figure this out.  It's either that or let Hank Paulson keep working on it, which is like watching a guy row a boat with one oar (He goes in circles I think)!  So here's a re-post:

I'm feeling mighty patriotic this morning as I watch "The Redeem Team" thrash the Chinese in B-Ball!  I don't even like basketball and I'm yelling things like, "get that weak-ass sh*t out of the paint!"  Speaking of weak-ass sh*t, what are we going to do with Fannie and Freddie?

I think the first thing we need to do is have a serious debate as to whether or not we want to keep subsidizing home ownership.  If we don't , then it's an easy answer. "Adios amigos." Before we rush to that decision however, lets talk a bit about how a very large part of housing finance currently works. 

1. Wells Fargo makes $1billion 30-year 6.5% fixed rate mortgage loans that will close mid to late September.  These loans conform to Fannie Mae and Freddie Mac underwriting guidelines.
2. Wells Fargo sells a $1 billion of Freddie Mac mortgage backed securities (MBS) to Credit Suisse MBS dealer desk, to settle in October for a price of 100-00 (par).
3. The rate on the MBS that Wells sells to Credit Suisse will be 6%.  The loans that will be making up the MBS are 6.5%.  What happened to that .50%?
4. Freddie Mac takes .12% of the 6.5% interest payment every month.  That is its premium to guarantee this mortgage backed security.
5. The remaining .38% of the interest payment is kept by Wells Fargo to compensate the company for servicing (collecting principal and interest, escrowing and paying for taxes and insurance, handling delinquencies, and if necessary dealing with the default and foreclosure process) the loans.
6. In October, Wells makes delivery of $1 billion Freddie Mac 6% MBS to Credit Suisse, who most probably has sold the bonds to an end investor.
7. Rinse, lather and repeat thousands and thousands of times.

You see that in step 4, Freddie (could be Fannie as well) provides the credit insurance which allows the eventual Freddie Mac MBS to trade credit risk free.  Currently, the amount of Freddie Mac and Fannie Mae 30-year Fixed Rate MBS outstanding is about $2.7 trillion.  This is the most liquid fixed income market in the world of finance.  It is heavily utilized by what we call "real money" like pension funds, money managers, banks, insurance companies, foreign governments, etc.  It is also heavily utilized by the very large hedge fund community.  This harmonious (keeping in spirit of the Olympic Games) relationship between dealers, real money and speculative money makes this market for Freddie Mac and Fannie Mae MBS extremely liquid.

Now, you may be saying to yourself, "Who cares?"  Well, everyone should care because when Wells Fargo sets its rate for your mortgage loan, it is zeroed in on the execution it gets when it sells your loan into what we call, the "secondary market".  If that secondary market breaks down, the whole machine breaks down and suddenly your 6.5% loan is a 8% loan. How do you think that will effect the economy?  This is how we have been subsidizing homeownership for at least twenty five years.  And up until recently, before everyone lost their minds, it worked pretty damn well.  The subsidy is Freddie and Fannie underwriting the credit insurance while being implicitly (now effectively explicitly) backed by the U.S. Government. 

Taking this method of subsidizing home ownership and replacing it with ideas that sound good but won't go much past the inaugural press conference (like covered bonds), will effectively cut off relatively cheap home financing.  If you think that is ok, then you can stop reading.  Personally, I think it would be catastrophic, and I say that in context of the current catastrophe!

I think the correct thing to do is first call in a team of forensic accountants to classify, that according to Generally Accepted Accounting Principals, both Freddie and Fannie are insolvent.  Once you go through the completely unreserved $35 billion of "Tax Deferred Assets" and the approximate $30 billion"Temporary" losses in the securities portfolios that haven't hit the income statement or equity, it's over and common and preferred stock goes to zero.  We can sit and wait another few months until the arithmetic takes care of things, but it will just be a waste of time and money.  I don't mean to be harsh, but this is the reality.  Freddie and Fannie will now be the prized property of The U.S. Government.

Next, we merge the two companies under the name of the more liquid MBS, Fannie Mae.  All Freddie Debt is converted to Fannie.  Additionally, Freddie Mac MBS would be converted to Fannie MBS.  There is a difference in interest rate calculation between Fannies and Freddies that will effect the conversion and have some nasty effects (or nice effects) on security holder earnings, but so be it.  In the grand scheme of all that is going on, its not a big deal.  Then we split the companies two main business lines into two distinct entities.

1. The mortgage credit insurance (or guarantor) business.
2. The Retained portfolio (the combined $1.5 trillion portfolio of mortgage investments funded with agency debt and hedged with interest rate swaps and options)

For the insurance business, we ring-fence the existing book of business.  This contains the bad business that will be generating billions of losses, but it also contains good historic business as well as the very good business Freddie and Fannie have been underwriting in 2008.  This will be the book that you and I own, and there will be losses.  However, there's good news!  Now that our "new" Fannie Mae is the only real game in town with regard to guaranteeing the credit of conventional conforming mortgages, they can charge a real nice premium for all new business done starting in 2009.  And trust me, all this will mean to you and I, as mortgage borrowers, is about .125% to .25% on your note rate. 

One of the big problems Freddie and Fannie caused for themselves is they got into an incredibly self-destructive price war with one another.  Normally, competition is good, and it was if you were Countrywide or one of the other big originators.  But that "competition" is one of the reasons Freddie and Fannie are now going toes up.  If you saw some of the deals the GSEs cut with the big originators to win their business from one another you would literally fall out of your chair!  Coming into this decade, the insurance business the GSEs had on their books was very strong.  It took approximately twenty five performing loans to make up for the loss of one bad loan.  By the time the price war ended, it took more than fifty loans to make up for one bad one!  Additionally, both companies spent millions, maybe billions in advertising and marketing.  Why did they do this you ask?  To win business from one another of course!  There's an expense you don't have to worry about anymore.  We won't have to spend another dime on lobbying either.  Oh, and Dan Mudd and Dick Syron can go back to what ever it was they were doing before the money fairy dropped them into their current positions.

So, once we get the pricing back in line, as Freddie and Fannie are already doing, I bet we can get a past GSE investor, Warren Buffet, to come back and participate in a joint venture.  He can come up with the first $2 billion by selling his 20% stake in that pile of garbage Moody's!  I can see him coming in with a good $10 billion and I bet we can get a syndicate of investors to raise some serious capital.  The government will have to kick in too, but this will be a profitable venture for all involved.

Now we have to deal with the $1.5 trillion retained portfolio.  Frankly, the GSEs, especially Freddie Mac, do a nice job with this part of the business.  It's essentially a gigantic mortgage hedge fund.  The guy who runs this at Freddie Mac may be the sharpest fixed income mind on the planet.  I'm not kidding.  They take the funding and the hedges and run it for us.  We'll have to put a few billion of capital in but it will be worth it.  With regard to funding, I like the idea Bill Ackman had.  Right now if you own 5-year Fannie or Freddie debt you are getting approximately .88% over the risk free 5-year Treasury note.  The main reason for that spread is potential credit risk (there's also liquidity risk but agency debt is plenty liquid).  Now, with the explicit backing of Uncle Sam, there is no credit risk.  To some degree, an agency debt holder is accruing the benefit now of a partial equity holder.  Ackman's idea was to convert a percentage of this debt, via a swap from holder to issuer, to preferred equity.  If you did it 90% debt and 10% equity, we would have all the capital we need for our mortgage hedge fund.

I think we can do this, keep the bedrock of our housing finance system in place, minimize losses and eventually create gains in the future to offset a good amount of this Fannie/Freddie debacle.

What to do With Fannie and Freddie?

I'm feeling mighty patriotic this morning as I watch "The Redeem Team" thrash the Chinese in B-Ball!  I don't even like basketball and I'm yelling things like, "get that weak-ass sh*t out of the paint!"  Speaking of weak-ass sh*t, what are we going to do with Fannie and Freddie?

I think the first thing we need to do is have a serious debate as to whether or not we want to keep subsidizing home ownership.  If we don't , then it's an easy answer. "Adios amigos." Before we rush to that decision however, lets talk a bit about how a very large part of housing finance currently works. 

1. Wells Fargo makes $1billion 30-year 6.5% fixed rate mortgage loans that will close mid to late September.  These loans conform to Fannie Mae and Freddie Mac underwriting guidelines.
2. Wells Fargo sells a $1 billion of Freddie Mac mortgage backed securities (MBS) to Credit Suisse MBS dealer desk, to settle in October for a price of 100-00 (par).
3. The rate on the MBS that Wells sells to Credit Suisse will be 6%.  The loans that will be making up the MBS are 6.5%.  What happened to that .50%?
4. Freddie Mac takes .12% of the 6.5% interest payment every month.  That is its premium to guarantee this mortgage backed security.
5. The remaining .38% of the interest payment is kept by Wells Fargo to compensate the company for servicing (collecting principal and interest, escrowing and paying for taxes and insurance, handling delinquencies, and if necessary dealing with the default and foreclosure process) the loans.
6. In October, Wells makes delivery of $1 billion Freddie Mac 6% MBS to Credit Suisse, who most probably has sold the bonds to an end investor.
7. Rinse, lather and repeat thousands and thousands of times.

You see that in step 4, Freddie (could be Fannie as well) provides the credit insurance which allows the eventual Freddie Mac MBS to trade credit risk free.  Currently, the amount of Freddie Mac and Fannie Mae 30-year Fixed Rate MBS outstanding is about $2.7 trillion.  This is the most liquid fixed income market in the world of finance.  It is heavily utilized by what we call "real money" like pension funds, money managers, banks, insurance companies, foreign governments, etc.  It is also heavily utilized by the very large hedge fund community.  This harmonious (keeping in spirit of the Olympic Games) relationship between dealers, real money and speculative money makes this market for Freddie Mac and Fannie Mae MBS extremely liquid.

Now, you may be saying to yourself, "Who cares?"  Well, everyone should care because when Wells Fargo sets its rate for your mortgage loan, it is zeroed in on the execution it gets when it sells your loan into what we call, the "secondary market".  If that secondary market breaks down, the whole machine breaks down and suddenly your 6.5% loan is a 8% loan. How do you think that will effect the economy?  This is how we have been subsidizing homeownership for at least twenty five years.  And up until recently, before everyone lost their minds, it worked pretty damn well.  The subsidy is Freddie and Fannie underwriting the credit insurance while being implicitly (now effectively explicitly) backed by the U.S. Government. 

Taking this method of subsidizing home ownership and replacing it with ideas that sound good but won't go much past the inaugural press conference (like covered bonds), will effectively cut off relatively cheap home financing.  If you think that is ok, then you can stop reading.  Personally, I think it would be catastrophic, and I say that in context of the current catastrophe!

I think the correct thing to do is first call in a team of forensic accountants to classify, that according to Generally Accepted Accounting Principals, both Freddie and Fannie are insolvent.  Once you go through the completely unreserved $35 billion of "Tax Deferred Assets" and the approximate $30 billion"Temporary" losses in the securities portfolios that haven't hit the income statement or equity, it's over and common and preferred stock goes to zero.  We can sit and wait another few months until the arithmetic takes care of things, but it will just be a waste of time and money.  I don't mean to be harsh, but this is the reality.  Freddie and Fannie will now be the prized property of The U.S. Government.

Next, we merge the two companies under the name of the more liquid MBS, Fannie Mae.  All Freddie Debt is converted to Fannie.  Additionally, Freddie Mac MBS would be converted to Fannie MBS.  There is a difference in interest rate calculation between Fannies and Freddies that will effect the conversion and have some nasty effects (or nice effects) on security holder earnings, but so be it.  In the grand scheme of all that is going on, its not a big deal.  Then we split the companies two main business lines into two distinct entities.

1. The mortgage credit insurance (or guarantor) business.
2. The Retained portfolio (the combined $1.5 trillion portfolio of mortgage investments funded with agency debt and hedged with interest rate swaps and options)

For the insurance business, we ring-fence the existing book of business.  This contains the bad business that will be generating billions of losses, but it also contains good historic business as well as the very good business Freddie and Fannie have been underwriting in 2008.  This will be the book that you and I own, and there will be losses.  However, there's good news!  Now that our "new" Fannie Mae is the only real game in town with regard to guaranteeing the credit of conventional conforming mortgages, they can charge a real nice premium for all new business done starting in 2009.  And trust me, all this will mean to you and I, as mortgage borrowers, is about .125% to .25% on your note rate. 

One of the big problems Freddie and Fannie caused for themselves is they got into an incredibly self-destructive price war with one another.  Normally, competition is good, and it was if you were Countrywide or one of the other big originators.  But that "competition" is one of the reasons Freddie and Fannie are now going toes up.  If you saw some of the deals the GSEs cut with the big originators to win their business from one another you would literally fall out of your chair!  Coming into this decade, the insurance business the GSEs had on their books was very strong.  It took approximately twenty five performing loans to make up for the loss of one bad loan.  By the time the price war ended, it took more than fifty loans to make up for one bad one!  Additionally, both companies spent millions, maybe billions in advertising and marketing.  Why did they do this you ask?  To win business from one another of course!  There's an expense you don't have to worry about anymore.  We won't have to spend another dime on lobbying either.  Oh, and Dan Mudd and Dick Syron can go back to what ever it was they were doing before the money fairy dropped them into their current positions.

So, once we get the pricing back in line, as Freddie and Fannie are already doing, I bet we can get a past GSE investor, Warren Buffet, to come back and participate in a joint venture.  He can come up with the first $2 billion by selling his 20% stake in that pile of garbage Moody's!  I can see him coming in with a good $10 billion and I bet we can get a syndicate of investors to raise some serious capital.  The government will have to kick in too, but this will be a profitable venture for all involved.

Now we have to deal with the $1.5 trillion retained portfolio.  Frankly, the GSEs, especially Freddie Mac, do a nice job with this part of the business.  It's essentially a gigantic mortgage hedge fund.  The guy who runs this at Freddie Mac may be the sharpest fixed income mind on the planet.  I'm not kidding.  They take the funding and the hedges and run it for us.  We'll have to put a few billion of capital in but it will be worth it.  With regard to funding, I like the idea Bill Ackman had.  Right now if you own 5-year Fannie or Freddie debt you are getting approximately .88% over the risk free 5-year Treasury note.  The main reason for that spread is potential credit risk (there's also liquidity risk but agency debt is plenty liquid).  Now, with the explicit backing of Uncle Sam, there is no credit risk.  To some degree, an agency debt holder is accruing the benefit now of a partial equity holder.  Ackman's idea was to convert a percentage of this debt, via a swap from holder to issuer, to preferred equity.  If you did it 90% debt and 10% equity, we would have all the capital we need for our mortgage hedge fund.

I think we can do this, keep the bedrock of our housing finance system in place, minimize losses and eventually create gains in the future to offset a good amount of this Fannie/Freddie debacle.

Freddie & Fannie Were Most Certainly On a Mission

Yesterday I watched Freddie Mac CEO Dick Syron interviewed by Maria Bartiromo on CNBC and I have to say both did a good job asking and answering many tough questions.  The foundation of many of Mr. Syrons answers centered around Freddie Mac fulfilling its "mission".  That mission, according to Mr. Syron, was the mission to provide affordable home finance to many Americans in order to fulfill the dream of homeownership for as many as possible.  This was a cornerstone in the Bush Administration's "Ownership Society."  One could definitely argue that this goal has been a primary goal of American domestic policy since the 1950's.  This was the reason for the very existence of Freddie Mac and Fannie Mae.  I am going to argue however, that since the mid-1990's, the real mission of Freddie and Fannie was to make the shareholders happy and enrich  the executives that benefited from happy shareholders.

Dick Syron came to Freddie Mac at a time where the very integrity of the company was in tatters.  In 2003, it was discovered that the company had engaged in multiple counts of fraudulent accounting practices.  The books and records of the company needed to be restated back to the year 2000.  It was also discovered that Freddie's accounting infrastructure was woefully incapable of supporting the financial accounting of one of the most complex financial companies on earth.  Mr. Syron was tasked with fixing the problem and to his credit, he did.  Many might have legitimate gripes about how he managed the process but from the macro perspective, Mr. Syron achieved his objective. 

Mr. Syron repeatedly said yesterday that the deterioration in Freddie's credit book was owed to the company being pressured to fulfill its affordable housing goals.  In this I think Mr. Syron is not painting a completely accurate picture.  It is certainly true that HUD was pressuring Freddie to step up its affordable housing efforts back in 2004.  I remember having sympathy for Mr. Syron at the time because Freddie and Fannie were being screamed at to reduce the massive interest rate risk of their retained portfolios, while simultaneously being yelled at to increase credit risk from another area of government and its constituents! 

However, if you look back at how Freddie Mac (Fannie too, but we'll deal with them tomorrow!) was run, certainly since the mid-1990's, it was all about placating the shareholders and getting paid.  Freddie Mac has two distinct businesses;

1. Mortgage insurance through the securitization of conventional, conforming mortgage loans.
2. Managing a highly leveraged portfolio of mortgage assets.

In the mid-1990's Freddie really started taking advantage of their cheap funding by exponentially increasing its retained portfolio and leveraging up the favorable net interest margin.  At the same time, credit losses began to drop precipitously.  The mortgage insurance business really started raking it in.  In fact, you know it was a great business at the time because one of the largest investors was Warren Buffett.  As many of you know, Mr. Buffett loves insurance models that collect lots of premiums and never have to pay off, who the hell wouldn't!  In the late 1990's however, Buffett began to see three things that bothered him;

1. The GSE's were competing with each other more aggressively each year, thus reducing insurance premiums.  Additionally, mortgage originators like Countrywide, were growing in strength and pushing back on the GSEs with regard to insurance premiums.
2. Defaults and losses on conventional, conforming mortgage loans were dropping very close to zero.  Therefore, at some point they had nowhere to go but up.
3. Freddie had levered up its retained portfolio about as far as Mr. Buffett was comfortable with. 

So in the late 1990's, one of Freddie's biggest shareholders called it quits, and Freddie probably agreed with his reasoning.  However, to offset the declining revenue in the insurance business as competition with Fannie Mae intensified and originators morphed from price takers to price makers, Freddie kept increasing the retained portfolio AND the leverage.  The bang for the buck was also being enhanced by declining funding costs as Freddie successfully marketed its exploding debt.  The money poured in and the stock price continued to rise, especially during the 1998 refinancing wave.  To keep shareholders happy, Freddie portrayed the image of "Steady Freddie", a incredibly consistent money making machine.  To insure this, Freddie spent billions on interest rate derivatives to properly hedge the retained portfolio.

Therefore, when accounting rules changed in late 2000, where bye Freddie would have to mark to market its derivative hedges while not marking a vast majority of its balance sheet to market, there was a big problem.  In volatile times the derivative hedges would do what you want them to do, swing around in price as they were the offset to the balance sheet risk.  However, huge swings in the derivative book would destroy the image of "Steady Freddie".  The equity investors had never been properly educated in how Freddie managed this complex risk.  They had "Steady Freddie" embedded in their brains.  It didn't matter that "Freddie" was actually showing it was "Steady" by the swings in its derivative book, as the market value of portfolio equity (MVPE) remained remarkably steady. The earnings volatility, due to the accounting rules, would freak investors out.  So what did Freddie Mac do?  They kept with "the mission" of course.  The engaged in multiple acts of accounting fraud to "smooth" earnings so as to keep the share price up and get the executives paid.

When the accounting fraud exploded in 2003, the old management was whisked out and Mr. Syron came in with a new team.  As I said before, they built the accounting infrastructure and began to mend fences with the government and rebuild their integrity.  However, the rise of the Wall Street securitization game was creating another shareholder problem for Mr. Syron and his circle.  The Street was grabbing huge, overall mortgage market share through its securitization of both Jumbo and non-prime mortgage loans.  GSE market share of the overall market began to drop precipitously.  The pressure was on to not only defend their turf but retake market share.  I am going to argue that the pressure from shareholders easily trumped pressure from HUD.  Freddie Mac began first by buying huge quantities of AAA rated subprime bonds.  They were the bid that drove hundreds of billions of subprime deals.  Then, despite the objections of many inside  of Freddie Mac, management began to compete with Wall Street to guarantee riskier and riskier mortgage loans.  If you look at some of the objectives of senior Freddie Mac management (you can find these on the company's website), their job was to "touch" as many loans as possible.

In 2006, when Freddie vastly increased its credit risk, Mr. Syron's "affordable housing mission" argument loses credibility. Nobody needed to be pressured to increase affordable housing finance.  Anyone whose breath could fog a mirror could get a $150,000 loan at the drop of a hat.  Mr. Syron's "mission" was to regain market share, make shareholders happy, and get himself and his inner-circle paid.  And they were paid!  Now however, that risk is crushing Freddie Mac.  Could this have been avoided?  I believe it could have been.  When it comes to housing, there's probably no collection of people who know more about it than Freddie Mac.  Their gut was telling them there was something wrong.  Mr. Syron could have gone to shareholders and told them he didn't want to fight a market share battle when mortgage insurance pricing had become delusional.  There was still plenty of regular prime mortgage business to be done.  He also could have raised more capital to take advantage of any future dislocation.  However, instead of decreasing leverage, he increased it.  Now he, Freddie Mac and all of us have to pay the price for Mr. Syron's "Mission Accomplished".

"Treasury Turns to Wall Street for Fannie and Freddie Advise" Trumps Cloned Pitbulls!

This morning is so chock-full of earnings releases and other important stories that I really was having a problem figuring out what I was going to write about first.  Freddie's earnings came out showing they were down $821 million for the quarter, cutting their dividend (the fact that they are allowed to pay ANY dividend after the events of July 12 should be a poke in the eye with a sharp stick for all of us) and taking $2.8 billion in credit charges on their insurance book and a $1 billion writedown on their subprime securities book.  Their estimates of .0012% losses in 2008 and .00014% in 2009 on their credit books are a bad joke.  Try moving the decimal point one big move to the right and then multiply by two and you'll get a reasonable number! 

There also was Citigroup announcing it may buy back $5 billion of Auction Rate debt and pay a $100 million fine for hoodwinking investors (partially through tainted research), at the same time as it is being reported that they plan on reversing the Spitzer-era reforms on separating equity research from investment banking.  That's awesome!    Provided that Citi can actually return to underwriting equity, this should provide much fodder for comedic blogging in future years.

There were at least four other stories I was considering as I thumbed through the Financial Times when I stopped to read, "Clones Turn Pitbull Loss Into Happy Tale."  It seems the South Koreans are cloning peoples pets and charging about $150,000 per cloned animal.  I was reading this article thinking,

"Cloning pitbulls, great.  It's not like that breed has any psychotic violence issues to begin with, lets clone a few hundred and see what happens.  Every drug lord in the U.S.A. will have an army of these mutant beasts!.

And then, I look to my left and see a TRULY SHOCKING ARTICLE!  "Treasury Turns to Wall Street for Fannie and Freddie Advise."  The coffee literally dribbled out of my slack-jawed mouth!  Quoting from the Times article;

"Henry Paulson, Treasury secretary and former Goldman Sachs chief executive is turning to his former Wall Street rivals for "market analysis and financial expertise" related to Fannie and Freddie which suffered a crisis of confidence last week leading Congress to approve a rescue plan for the two groups."

They are out of their minds, they really are.  My favorite part is Paulson has been talking to John "The Capital Cremator" Mack at Morgan Stanley about Stanley being the chief adviser.  Forget about the fact that Treasury should have people that know a hell of a lot more than Morgan Stanley investment bankers, but Morgan Stanley and practically the rest of The Street have proved that when it comes to residential mortgage credit risk, they know LESS than either Freddie, Fannie and Treasury!  Does Paulson not understand that it was this stunning mispricing of risk by The Street (aided by the ratings companies) that caused this whole problem to begin with?  The fact that Paulson turned to Morgan Stanley, one of the late to the party group that plowed in with both feet at the VERY TOP of the market is amazing.  Why doesn't Paulson see what Stan O'Neal and Dow Kim, formerly from Merrill Lynch, have to say?

Now, I know that Stanley's advise will be limited to just "capital markets" advice and, "not expected to include work on the future status of Fannie Mae and Freddie Mac", but how do you really separate the two and be effective?  I don't think you can, and Morgan Stanley's track record makes you really wonder what value they are going to add.  Additionally, I've seen the work that investment bankers have done in the past on Freddie and Fannie, and you can write a very large book on what they didn't understand.  Treasury and Morgan Stanley were quick to point out that the mandate for Morgan Stanley is prestigious and that Stanley will be waiving any fees.  Additionally, this work will prohibit Morgan Stanley from participating in any future underwriting of any capital raising by either GSE over the next few months.  Big whoop!  There is going to be exactly one capital raise from Freddie and then it's Treasury's turn. 

So why would Morgan Stanley be so anxious to do this?  Well, yesterday it was reported that Morgan Stanley froze thousands of clients home equity credit lines of credit.  A little cashflow problem perhaps?  Additionally, Morgan Stanley has about $20 billion funding to roll in 2009.  I have a strong feeling as this credit crisis intensifies, Stanley, along with Lehman and Merrill are going to have to turn to the Fed's Primary Dealer Credit Facility.  That's the fund that lends tax-payer money against collateral that we should be dropping on the Taliban!  Therefore, in my twisted, cynical mind, I think Morgan Stanley just bought themselves at least one, get out of jail free card.  When everyone gets rightfully up in arms next year as the government spends billions to keep them afloat, someone can say, "Look at all the selfless and patriotic work they did advising Treasury on the GSE's."  That's what I think.

Fannie and Freddie Know it's Bad When Their Only Champion is....Frank Raines!

Frank Raines has written another stirring Op-Ed piece, this time in The Wall Street Journal.  When Mr. Raines wrote his last piece a couple of weeks ago in The Washington Post we wondered here, "If I were that dude, instead of writing op-ed pieces I would be quietly wiring ALL my money to some friendly off-shore bank, packing my stuff and getting on a private plane and going to a place they can never find me!"

In this piece Raines despairs that, "After almost 10 years of Fannie and Freddie wars, has the policy and political contest over the future of the government-sponsored enterprises been resolved by the passage of the Housing and Economic Recovery Act of 2008? Apparently not."  Raines goes on to state the facts "as he sees them";

1. The current losses have nothing to do with the "accounting restatements" of several years ago.
2. Fannie and Freddie do not have "out-sized losses from the meltdown in subprime mortgages.
3. The losses at Fannie and Freddie do not result from their large off balance sheet portfolios.
4. The shareholders of Freddie and Fannie have not received windfall profits in the past for which they should be punished today.
5. The companies have not received a bailout.  Treasury just has asked for and received standby authority to act.

Ok, lets take them in order received.  Technically, Mr. Raines is right on point one.  However, I don't think you can look at the actions of the companies in 2003-present without considering that the restatement process both companies went through, due to fraudulent accounting, consumed vast human AND financial resources.  Lets not forget that Freddie and Fannie paid billions (yes, that is billions with a "B") to restate their earnings.  Don't tell me that these monster expenses didn't cause the risk spigot to be opened much wider in 2004 and onward.  One probably doesn't happen without the other.

To Mr. Raines second point, yes the losses are not "out-sized" if your talking about percentage of portfolio that goes bad.  But what Mr. Raines conveniently leaves out is when you are leveraged 45 to 1 or more, it only takes credit risk portfolio losses to equal 3% (say 15% defaults with 20% severity) to wipe you out!  That is exactly what is going on right now with Fannie and Freddie's combined $3.5 trillion mortgage credit guarantee book and Freddie's $200 billion subprime security portfolio.  So to Mr Raines we say, "If it looks like insolvency and it sounds like insolvency, it's insolvency!"

We'll give Mr. Raines point three, the off-balance sheet comment because no one is blaming that portfolio (mostly hedges against convexity risk) anyway.  With regard to point four, shareholders have not received windfall gains in the past, that is just not right.  If we look at Fannie Mae we can see that for years (lets use 1998-2005) they ran their interest rate risk book of business grossly under-hedged.  If you went back to the period in question you would see that Fannie Mae use to make a net interest margin of about 1.1% on its retained portfolio.  Freddie Mac used to make about 0.70% at the same time.  How could that be if they were essentially funding at the same rate and buying the same mortgages?  It was because Freddie Mac bought the necessary interest rate options to hedge correctly.  Fannie Mae did not.  Therefore when interest rates became extremely volatile, Fannie lost billions, which is why they played games with their accounting books.  With regard to Freddie Mac's windfall, just look at what is being talked about today.  Freddie played their credit business fast and lose to sooth shareholders and regain market share of a toxic market. 

Finally, Mr Raines assertion that Fannie and Freddie have not been bailed out yet is again, technically true.  However, does Mr. Raines or anybody with an ounce of common sense think that if Treasury announced today that they were not standing behind Fannie and Freddie that both companies wouldn't vaporize in about 15 minutes?  Fannie and Freddie have been bailed out Mr. Raines and you know it.