Fannie: Going Concern, but I am Getting Concerned

Fannie Mae lost a reported $29 Billion in Q3. Over the past 7 quarters, they have now lost ALL earnings associated with the housing boom.

But after the $100 Billion Treasury injection and a variety of new liquidity facilities, the future must look bright... right? Well, maybe once they get past problems associated with their soon to be negative net worth, lack of liquidity, and bad loans. Lets get some more details.

Net Worth:

Under the Regulatory Reform Act, the Federal Housing Finance Agency MUST place Fannie Mae into receivership if their assets are less than obligations for a period of 60 days (I'll believe that when I see it).

Net worth is down from $44.1 Billion as of December 2007, to a reported $9.4 Billion at the end of September 2008. Of that $9.4 Billion, almost half is deferred taxes (i.e. provides no benefit without futures earnings).

Liquidity:

This past September, the Treasury made available two additional sources of funding to Fannie Mae; the Treasury credit facility and the senior preferred stock purchase agreement (i.e. the $100 Billion). Unfortunately this hasn't helped much; according to Fannie Mae in their 10-Q:

We have experienced reduced demand for our debt obligations from some of our historical sources of that demand, particularly in international markets.

Well if you keep making the following statements, you won't need to search for a reason why:

The U.S. government does not guarantee, directly or indirectly, our securities or other obligations.

Hmm.... just a few weeks back Federal Housing Finance Agency James Lockhart declared:

A government takeover of the two companies gives the companies “access to credit from the U.S. Treasury (and) an explicit guarantee to existing and future debt holders of Fannie Mae and Freddie Mac”

What's important is that the market agrees with Mr. Lockhart, as Fannie MBS currently trades within 5 bps of Ginnie MBS, which is absolutely guaranteed by the U.S. Government. The problem is the lack of liquidity in credit markets for anything with longer dated maturites outside of Treasuries.

Managing Problem Mortgage Loans and Preventing Foreclosures:

Finally, lets review the quality of Fannie's mortgage pools. After all, we are told on Fannie's website that:

Fannie Mae first ensures that the loans it acquires generally meet its credit quality guidelines and then it securitizes the pool of mortgages.

Unfortunately, even high quality loans can become non-performing in this environment. Non-perfoming loans are almost twice the level seen just nine months ago.

Conclusion:

There is absolutely no way any Agency MBS will be allowed to fail as the outcome would be disastrous. At the same time, putting Fannie and Freddie on the Treasury Balance Sheet is not an option as there is incentive to keep up the appearance of Fannie as a "going concern" regardless of how much money they lose (this would require too much transparency). In other words, I expect the original $100 Billion to just be a drop in the bucket.

Cheaper Fannie Financing...

Source: Accrued Interest

New "Bailout" Liabilities = Existing Publicity Traded Debt of U.S.

FT (HT Credit Writedowns):

The two mortgage companies have between them $5,400bn in liabilities, equal to the entire publicly traded debt of the US, alongside mortgage-related assets of about equal value. These will now all be accounted for by the CBO, although public accounting rules mean that its tally of US government debt may not necessarily increase by $5,400bn.

Fannie / Freddie Portfolios: $250B by 2021

The GSEs’ retained portfolios may not exceed $850 billion through December 31, 2009, after which time they will be reduced by 10% per year until they reach $250 billion.

Currently Fannie and Freddie have about $150B of capacity left between them based on that $850B "hard line". A 10% reduction in that figure per year means it will take until 2021 to reach the $250B goal. That means 3 different presidential terms will need to come and go, with each exercising fiscal restraint to make that happen.

Considering that just 5 years ago we were promised a small, fiscally responsible government and our minds seem to trick us into thinking things have materially changed every 3-5 years, does anyone believe this will happen? Case in point, just a little over two years ago Countrywide (and others) were ready to make Fannie and Freddie a thing of the past... in fact Countrywide's market cap peaked less than 2 years ago and remained well above 20 through last November.

Top Five (Former) Equity Holders of Fannie / Freddie

WSJ (HT Calculated Risk):

Wells Fargo & Co. said ... its perpetual preferred investments in Fannie and Freddie are included in securities available for sale at a cost of $336 million and $144 million, respectively. Those securities now trade at 5% to 10% of their original value.

The F&F confessional is open.

Source: MSN HT Dealbreaker; WSJ

A Picture is Worth 1000 Words... Fannie MBS Edition

Fannie Spreads WAY In...

IN A PERFECT WORLD: BAILOUT = END OF CREDIT CRISIS

Over the past few weeks there has been much criticism over the potential (now actual) Government Sponsored Agency “GSE” bailout due to the potential cost to taxpayers, the moral hazard it would encourage, etc... I do not disagree with most of these criticisms, but the cost of NOT doing anything would be much greater. To show the potential benefits of the bailout on both housing and credit markets, which in turn will benefit the economy, below is how the bailout will unfold in a “best case” scenario. While I do not believe it will solve all of the problems detailed below (or even a fraction of them) in this manner, I do believe it is important to look at the bail-out in terms of a "glass half full" and how it can help alleviate the liquidity problems associated with today’s credit markets.

I) BAILOUT DETAILS
Specific features of the bailout that impact the outcome to the credit market include the Feds new liquidity facility, the goal to increase Fannie and Freddie's mortgage-backed security portfolios through the end of 2009, the right for the Treasury to actively purchase MBS in the open market to reduce spread (and cost to future homeowners), and the future goal to reduce the GSE balance sheet by 10% annually starting in 2010. In the first part of my "perfect world" analysis, I predict that these features (and others – go here for 10 key features) will help put a floor on housing prices.

II) RATES MATTER

Homeowners that already qualify for high quality prime loans will not be as impacted directly by the new moves by the Fed. Why? Agency spreads are near historic wides, but absolute levels are already near historic lows.

HOWEVER, borrowers that do not currently qualify for these low rates should see their rates drop dramatically. Why is this important? If a homeowner that qualified for a 9.5% rate can access a 7% government “subsidized” loan, their buying power increases by almost 25% (all else equal).

These “subsidized” loans will prop up the housing market as the size of the payment made is what truly matters for a homeowner (specifically one that intends to live in that home for the foreseeable future). Importantly, these rates are not “teaser” rates that reset, but more manageable fixed rates for the life of the mortgage.

III) THE IMPORTANCE OF ATTRACTING THE MARGINAL BUYER TO THE MARKET
The goal is to entice the marginal buyer to come to the market / have “bad loans” refinance at more manageable rates. In the past 6-12 months potential homeowners have been sitting on the sideline as prices continue to make new lows (nobody wants to catch a falling knife). With the new “bailout” limited time horizon (increasing balance sheet through 2009), this SHOULD bring a sense of urgency for new homeowners (expect emphasis on the "limited time offer" aspect).

If these low rates do put a floor on home prices sooner than later, this should benefit the owners of subprime / Alt-A securities that have priced down as delinquencies have risen at historic levels. If the market bottoms and these owners are able to refinance at the new lower rates, get who gets off the hook? THE EXISTING MORTGAGE OWNERS who get paid back at PAR for all loans refinanced.

IV) BANKS FINALLY ABLE TO DELEVER AND MAKE NEW LOANS
Banks own a lot of these mortgage securities that have priced down and in response, over the past 6-9 months banks have attempted to delever as their equity has been written down / capital has been so difficult to come by. This system wide delevering only caused these entities to be more levered. How is this possible?

Well, if one bank attempted to delever, they’d be successful. When every bank attempts to do so at the same time, it only makes the problem worse! Let’s take a look…

As these banks all sold off assets at the same time, these assets sold priced down in value as the entire market was selling into a distressed AND illiquid market. This in turn reduced the price of assets remaining at the banks. When that happened, they were forced to write down even more assets / equity, resulting in leverage HIGHER THAN WHEN THEY INITIALLY BEGAN.

If these assets snap back even partially in value, the reverse happens. In fact, I expect a portion (maybe a tiny portion) of the underlying mortgages in securities marked as low as 60 cents on the dollar to repay at PAR when homeowners sell to new owners at the “subsidized” rate or are able to refinance themselves. In addition, liquidity injected into the market through the Treasury’s outright purchase of mortgages should bump up the price. The result will be improved leverage ratios at banks, which will slow the asset selling process we've seen from banks. In fact, expect well funded banks to actively buy securities in the market in the coming weeks / months.

It's also important that the bailout makes banks much more attractive for outside investment (think Sovereign Wealth Funds). Once new capital is injected and their balance sheets are improved, new loans can be made. This should result in improved (lower) rates for non-government mortgages.

V) THE CREDIT CRISIS ENDS?
If this all works out as I detailed in the above best case scenario, a functioning credit market at no cost to taxpayers results. What likely will happen? After everything that has transpired over the past 12+ months, I have no idea though I do expect credit markets to more accurately reflect the actual economy and not the lack of liquidity in markets. The result of which might scare investors just the same...

Outstanding Mortgages: Agency vs. Non-Agency

Source: Pioneer Investments

Agency MBS: Cheap or "Mispriced" Options?

Fannie MBS (as defined by 30 Year current coupon TBA), is historically cheap on an option adjusted spread "OAS" to Fannie's Agency Debt (as defined by its 5 year CDS spread) basis, widening even further since last month when I asked "Are Fannie Mortgages Cheap or is its Debt Expensive?"

In researching the topic I came across an interesting post over at Accrued Interest challenging this relative cheapness:

But times are anything but typical. Various conditions are coming together which will keep homeowners in their current residence far longer than historic norms. There is a large number of homeowners currently underwater on their mortgage, and an even larger number with less than 20% equity. Given that getting a mortgage with less than 20% down payment is difficult and very expensive right now, homeowners who currently have less than 20% equity would have to come up with a lot of cash in order to move to another home.

So the housing turnover element of mortgage principal payments is set to plummet. In addition, the same factors will prevent many refinancings. A borrower underwater on his current mortgage will not be able to refinance his loan just because rates fall 50bps.

This means that the average life of a mortgage is longer than is currently being assumed.

For example, a Fannie Mae 30-year 6% mortgage security currently has a nominal yield of 6.19% and an average life of 5 years. The average life is the median of a Bloomberg survey on prepayment estimates. That calculates to a nominal yield spread of 271bps.

Note that a 6% mortgage security is typically made up of borrowers with a 6.5% mortgage. Currently mortgage borrowing rates are 6.26%, according to Freddie Mac. Under normal conditions, one would assume that a 6.5% borrower is relatively close to a refinancing opportunity. Hence Wall Street prepayment models are assuming that this mortgage will pay principal slightly faster than this time last year.

More likely is that mortgages will prepay at historically slow rates. Cutting Wall Street's estimated prepayments in half, the mortgage's average life goes from 5 years to 9 years. Because the yield curve is so steep, that results in the yield spread falling to 219bps. If you cut Wall Street's estimate by a third, the spread falls to 202bps.

As investors come to terms with the extending average lives, prices are likely to fall rather than yield spreads contract. Holding the 271bps yield spread constant but extending the average life to 9 years causes the price to drop by over 3%.

Why didn't I think of that?

Source: Accrued Interest

Putting the BS Back in MBS

Below is an EconomPic'd version of a great table posted at Calculated Risk which summarizes the percentage of loans with high loan to value "LTV" and/or low FICO (credit) scores made over the last five years. Specifically shown are fixed 30 year loans and fixed interest only "I/O" 10/20 loans (the interest-only portion runs for 10 years and then fully amortizes over the remaining 20- year term).


So what does it show? It shows that recent loans have gotten a whole lot riskier for taxpayers Fannie and Freddie, especially if prices continue to slide.

S&P: Fannie Subordinated Debt Holders May be In Trouble

Per Dealbreaker:

Will the government's bailout of Fannie Mae and Freddie Mac wipe out holders of their preferred stock and subordinated debt? That's what S&P warned today with its statement that it was placing these instruments on a negative credit watch pending a review of the legislation on Capitol Hill.

"Although there is still ambiguity on the part of regulatory authority as it applies to how nonsenior creditors of Fannie Mae and Freddie Mac would be treated if the U.S. Treasury ever acted on its three-point liquidity plan, the language in HR 3221 increases the likelihood that subordinated debtholders and preferred stockholders would face greater subordination risk," S&P's analyst wrote.

Update: Yves over at Naked Capitalism points out the downgrade:

Validates some of the critics' worries about Fannie and Freddie but also signals the possibility that not only shareowners could be wiped out, but even preferred stockholders and sub debt owners are exposed even with the government rescue effort. Put more simply, this move the view that the firms are undercapitalized.

Are Fannie Mortgages Cheap or is its Debt Expensive?

The government is willing to backstop Fannie so Fannie can backstop their Mortgage Backed Securities "MBS" if needed to.

So why is the MBS trading ~100 bps cheap to their debt (OAS less CDS) after trading MORE EXPENSIVE JUST SIX MONTHS AGO? Interesting times...