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I would imagine that only during the past couple of weeks has management begun to recognize the looming disaster confronting the GSEs. Sure, Fannie Mae has struggled (at times unsuccessfully) through past downturns. But never has a financial institution entered a historic housing bust with a “Book of Business” of mortgages, MBS and other Credit guarantees of $2.716 TN. This massive Credit exposure is backed by a $39.9bn sliver of Shareholder’s Equity.
The GSEs are the Kings of “structured finance.” On its $840bn balance sheet, Fannie holds $106bn of “private-label” MBS, the majority subprime and Alt-A. “Advances to Lenders” almost doubled in nine months to about $11.7bn. And they are today the “beneficiary” on $457bn of mortgage insurance. Responding to a question regarding the viability of the mortgage insurance industry they so depend, management stated that their internal analysis gave them confidence that the mortgage insurers had ample capital to survive the cycle. We and the marketplace have serious doubts. In their management of huge interest-rate risk, they have accumulated notional derivative positions to the tune of $814bn. Whether it is an unexpected (systemic) surge in Credit losses or major move in rates, the GSEs have grown too large for their derivatives to protect them. A devastating housing bust will bankrupt the mortgage insurers, while the solvency of their derivatives counterparties going forward will be in doubt in any number of scenarios. The GSEs are now integrally linked to what I expect to be Credit insurance’s and "structured finance's" astonishing downfall.
... and I’ll stick with my forecast that California and the West Coast will bankrupt the GSEs.
...Not surprisingly, Fannie is responding to deteriorating lending conditions as many typically do: Expand new business aggressively to offset mounting Credit losses and bet the ranch on growing your way out of trouble..."
...Meanwhile, a backbreaking Credit Crunch is about to strangle the U.S. Bubble economy. “Structured finance” is a bust, while the major banks now recognize that this much more than a fleeting liquidity crisis. To survive, they will move aggressively to get their risk under control. If there were a more ominous scenario than the one developing, I’ve not thought of it."
Fannie in Her Own WordsBy Doug Noland
November 9, 2007
SourceThe following paragraphs were extracted from Fannie Mae’s third-quarter 10-Q filing, issued this morning:
“We generate revenue by absorbing the credit risk of mortgage loans and mortgage-related securities backing our Fannie Mae MBS in exchange for a guaranty fee. We primarily issue single-class and multi-class Fannie Mae MBS and guarantee to the respective MBS trusts that we will supplement amounts received by the MBS trust as required to permit timely payment of principal and interest on the related Fannie Mae MBS, irrespective of the cash flows received from borrowers. We also provide credit enhancements on taxable or tax-exempt mortgage revenue bonds issued by state and local governmental entities to finance multifamily housing for low- and moderate-income families. Additionally, we issue long-term standby commitments that require us to purchase loans from lenders if the loans meet certain delinquency criteria...”
“Like other participants in the U.S. residential mortgage market, we have experienced and expect to continue to experience adverse effects from this market correction, which are reflected in our financial results. These include: Our credit losses and credit-related expenses have increased significantly due to national home price declines and economic weakness in some regional markets. Our ‘Losses on certain guaranty contracts’ have increased significantly… Because of the significant disruption in the housing and mortgage markets during the third quarter of 2007, the indicative market prices we obtained from third parties in connection with our purchases of delinquent loans from our MBS trusts have decreased significantly. This has caused us to reduce our estimates of the fair value of these loans, resulting in a significant increase in our initial recorded losses from these purchases…”
“Our credit-related expenses consist of our provision for credit losses and our foreclosed property expense. Our credit-related expenses increased to $1.2 billion for the third quarter of 2007, from $197 million for the third quarter of 2006. Credit-related expenses increased to $2.0 billion for the first nine months of 2007, from $457 million for the first nine months of 2006. Following is a discussion of changes in the components of our credit-related expenses for each comparable period. The provision for credit losses increased by $942 million, or 650%, to $1.1 billion for the third quarter of 2007, from $145 million for the third quarter of 2006. The provision for credit losses increased by $1.4 billion, or 381%, to $1.8 billion for the first nine months of 2007, from $368 million for the first nine months of 2006.
Approximately $670 million and $805 million of the provision for credit losses for the three and nine months ended September 30, 2007, respectively, relates to charge-offs recorded when we purchase delinquent loans from MBS trusts and the purchase price…exceeds the fair value at the purchase date… Accordingly, $633 million and $652 million of the increase in the provision for credit losses for the three and nine months ended September 30, 2007, respectively, was attributable primarily to a substantial decrease in the market value of delinquent loans we purchased from MBS trusts. The decrease began in July 2007 as housing and credit market conditions deteriorated, causing increased credit spread requirements and decreased liquidity for this type of asset…”
We are required by our MBS trust agreement to purchase loans from an MBS trust when specified predetermined triggers are met. Accordingly, we would expect to continue to incur these charges as part of our provision for credit losses in our consolidated financial statements. We do not expect the market prices for these delinquent loans to improve in the reasonably foreseeable future. The remaining increase in our provision for credit losses of $309 million and $750 million for the three and nine months ended September 30, 2007, respectively, is attributable to an increase in net charge-offs and incremental additions to the allowance for loan losses and reserve for guaranty losses during each period. The increase in net charge-offs in each period reflects higher default rates and an increase in the average amount of loss per loan, or charge-off severity…”
The increase in charge-off severity is attributable to the combined effect of the national decline in home prices and the higher unpaid principal balances of loans going to foreclosure. Foreclosed property expense increased by $61 million, or 117%, to $113 million for the third quarter of 2007… Foreclosed property expense increased by $180 million, or 202%, to $269 million for the first nine months of 2007… These increases were driven by an increase in the inventory of foreclosed properties and rapidly declining sales prices on foreclosed properties, particularly in the Midwest, which accounted for the majority of the increase in our foreclosed property expense in each period. The national decline in home prices has contributed to further increases in foreclosure activity.”
“Alt-A and Subprime Securities: We held approximately $106.2 billion in non-Fannie Mae structured mortgage-related securities in our investment portfolio as of September 30, 2007. Of this amount, $76.2 billion consisted of private-label mortgage-related securities backed by subprime or Alt-A mortgage loans…”
“To date, we generally have focused our purchases of private-label mortgage-related securities backed by subprime or Alt-A loans on the highest-rated tranches of these securities available at the time of acquisition… In 2007, we began to acquire a limited amount of subprime-backed private-label mortgage-related securities of investment grades below AAA. As of September 30, 2007, approximately $441 million in unpaid principal balance… We have not recorded any impairment of the securities classified as available-for-sale, as they continue to be rated investment grade and we have the intent and ability to hold these securities until the earlier of recovery of the unrealized amounts or maturity.”
“The increase in our single-family serious delinquency rate…was due to continued economic weakness in the Midwest, particularly in Ohio, Michigan and Indiana, and to the continued housing market downturn and decline in home prices throughout much of the country. We have experienced increases in serious delinquency rates across our conventional single-family mortgage credit book, including in higher risk loan categories, such as subprime loans, Alt-A loans, adjustable-rate loans, interest-only loans, loans made for the purchase of investment properties, negative-amortizing loans, loans to borrowers with lower credit scores and loans with high loan-to-value ratios. We have seen particularly rapid increases in serious delinquency rates in some higher risk loan categories, such as Alt-A loans, interest-only loans, loans with subordinate financing and loans made for the purchase of condominiums. Many of these higher risk loans were originated in 2006 and the first half of 2007. We have also experienced a significant increase in delinquency rates in loans originated in California, Florida, Nevada and Arizona. These states had previously experienced very rapid home price appreciation and are now experiencing home price declines. The conventional single-family serious delinquency rates for California and Florida, which represent the two largest states in our single-family mortgage credit book of business in terms of unpaid principal balance, climbed to 0.30% and 0.99%, respectively, as of September 30, 2007, from 0.11% and 0.37%... We expect the housing market to continue to deteriorate and home prices to continue to decline in these states and on a national basis. Accordingly, we expect our single-family serious delinquency rate to continue to increase for the remainder of 2007 and in 2008...”
“Mortgage Insurers: As of September 30, 2007, we were the beneficiary of primary mortgage insurance coverage on $329.0 billion of single-family loans in our portfolio or underlying Fannie Mae MBS, which represented approximately 14% of our single-family mortgage credit book of business, compared with $272.1 billion, or approximately 12%, of our single-family mortgage credit book of business as of December 31, 2006. In addition, as of September 30, 2007, we were the beneficiary of pool mortgage insurance coverage on $128.3 billion of single-family loans, including conventional and government loans, in our portfolio or underlying Fannie Mae MBS, compared with $106.6 billion as of December 31, 2006.
Two of our seven primary mortgage insurers have recently had their external ratings for claims paying ability or insurer financial strength downgraded by Fitch from AA to AA-… As of September 30, 2007, these two mortgage insurers provided primary and pool mortgage insurance coverage on $59.1 billion and $27.8 billion, respectively… Ratings downgrades imply an increased risk that these mortgage insurers will fail to fulfill their obligations to reimburse us for claims under insurance policies. We continue to closely monitor our exposure to our mortgage insurer counterparties…”
“Recent Events Relating to Lender Customers and Mortgage Servicers: Mortgage and credit market conditions deteriorated rapidly in the third quarter of 2007. Factors negatively affecting the mortgage and credit markets in recent months include significant volatility, lower levels of liquidity, wider credit spreads, rating agency downgrades and significantly higher levels of mortgage foreclosures and delinquencies, particularly with respect to subprime mortgage loans. These challenging market conditions have adversely affected, and are expected to continue to adversely affect, the liquidity and financial condition of a number of our lender customers and mortgage servicers. Several of our lender customers and servicers have experienced ratings downgrades and liquidity constraints, including Countrywide Financial Corporation and its affiliates, our largest lender customer and servicer. The weakened financial condition and liquidity position of some of our lender customers and mortgage servicers may negatively affect their ability to perform their obligations to us and the quality of the services that they provide to us. In addition, our arrangements with our lender customers and mortgage servicers could result in significant exposure to us if any one of our significant lender customers were to default or experience a serious liquidity event. The failure of any of our primary lender customers or mortgage servicers to meet their obligations to us could have a material adverse effect on our results of operations and financial condition…”
“Derivatives Activity: The primary tool we use to manage the interest rate risk implicit in our mortgage assets is the variety of debt instruments we issue. We supplement our issuance of debt with derivative instruments, which are an integral part of our strategy in managing interest rate risk… The outstanding notional balance of our risk management derivatives increased by $69.0 billion during the first nine months of 2007, to $814.4 billion as of September 30, 2007…”
Company management put a brave face on their predicament throughout this afternoon’s analyst conference call. They’ve been through tough housing downturns before, they comforted the analyst community. Although increasing Credit losses are an obvious concern, the management team is excited by opportunities presented by the difficult current environment. They assured everyone that they have a plan. More likely, they’ve been caught flat-footed by the nature of the unfolding Credit crisis.
I would imagine that only during the past couple of weeks has management begun to recognize the looming disaster confronting the GSEs. Sure, Fannie Mae has struggled (at times unsuccessfully) through past downturns. But never has a financial institution entered a historic housing bust with a “Book of Business” of mortgages, MBS and other Credit guarantees of $2.716 TN. This massive Credit exposure is backed by a $39.9bn sliver of Shareholder’s Equity.
The GSEs are the Kings of “structured finance.” On its $840bn balance sheet, Fannie holds $106bn of “private-label” MBS, the majority subprime and Alt-A. “Advances to Lenders” almost doubled in nine months to about $11.7bn. And they are today the “beneficiary” on $457bn of mortgage insurance. Responding to a question regarding the viability of the mortgage insurance industry they so depend, management stated that their internal analysis gave them confidence that the mortgage insurers had ample capital to survive the cycle. We and the marketplace have serious doubts. In their management of huge interest-rate risk, they have accumulated notional derivative positions to the tune of $814bn. Whether it is an unexpected (systemic) surge in Credit losses or major move in rates, the GSEs have grown too large for their derivatives to protect them. A devastating housing bust will bankrupt the mortgage insurers, while the solvency of their derivatives counterparties going forward will be in doubt in any number of scenarios. The GSEs are now integrally linked to what I expect to be Credit insurance’s and "structured finance's" astonishing downfall.
Fannie Mae lost $1.39bn during the third quarter. The company marked down its derivative hedging position by $2.24bn, although this loss was supposedly offset by the rising value of its assets (chiefly mortgages) in a lower rate environment. More disconcerting was the rapid surge in Credit costs. “Charge-offs, net of recoveries” jumped to $838 million during Q3, up eight-fold from the year ago $104 million. Fannie acquired 34,955 properties through foreclosure during the first nine months of the year, up 34% y-o-y. The “carrying value” of foreclosed properties during the nine months jumped 53% y-o-y to $2.913bn. And while the Midwest has the highest serious delinquency rate (1.14%), it is worth noting that the West showed the most rapid deterioration over the past year (doubling to .33%). This region also posted the fastest growth in foreclosed properties during Q3. The West accounts for 23% of Fannie’s exposure, and I’ll stick with my forecast that California and the West Coast will bankrupt the GSEs.
CEO Daniel Mudd addressed deteriorating Credit conditions during the conference call: “We previously said that our credit loss ratio would be in the range of 4 to 6 basis points this year. That is still what we expect. Going forward, projecting a 4% national decline in home prices and a scenario where there is not a nationwide recession, we can see our credit loss ratio move into the range of 8 to 10 basis points next year.”
A “scenario where there is not a nationwide recession?” Well, steeper home prices declines and a deep recession appear at this point a much more probable scenario. Quarterly Credit cost can be expected to grow to the multi-billions. Not surprisingly, Fannie is responding to deteriorating lending conditions as many typically do: Expand new business aggressively to offset mounting Credit losses and bet the ranch on growing your way out of trouble. In the face of rapidly escalating Credit problems and myriad market risks, Fannie expanded its “Book of Business” $98bn during the third quarter. Fannie’s “Book” inflated $243bn during the first nine months of the year, as Shareholders’ Equity declined $1.6bn. It is as well worth noting that Fannie's and Freddie's combined "Books of Business" had expanded at a 13.2% rate y-t-d ($430bn) through September to $4.78 TN, with a y-o-y rise of $516bn (12.1%).
Spreads (to Treasuries) on GSE debt and their MBS widened markedly this week. These perceived safe and liquid “money-like” debt instruments have for some time been an instrument of choice for highly leveraged speculation. I have no idea to what extent these instruments have been part of the infamous “yen carry” trade. But I do know that the yen rallied strongly this week, further pressuring the leveraged players and significantly exacerbating the unfolding Credit Crisis. And the beloved technology stocks - the favored long equities trade of the leveraged speculating community - were hammered. Meanwhile, the CDO market came under further stress and even the “emerging” debt markets reversed course. It is difficult for me to believe that the “sophisticated money” will not now attempt to be the first ones out of the hedge fund Bubble. Meanwhile, a backbreaking Credit Crunch is about to strangle the U.S. Bubble economy. “Structured finance” is a bust, while the major banks now recognize that this much more than a fleeting liquidity crisis. To survive, they will move aggressively to get their risk under control. If there were a more ominous scenario than the one developing, I’ve not thought of it.