More data, that is, and more questions.
I’ve been a little slow in commenting on this story from last month’s Washington Post (hat tip: Tanta):
Freddie Mac, still fixing weaknesses that came to light in 2003, yesterday issued its first timely annual report in five years.
Freddie now has annual reports for 2004, 2005, and 2006 linked from its webpage, correcting an alarming deficiency that I had earlier highlighted. Elsewhere, the San Diego City Employees’ Retirement System also managed to finally get their 2004 annual report up, doubtless also in response to my complaints. I see that when Econbrowser gripes, stuff happens! [Note to SDCERS– wouldn’t it be cool now to get the 2005 and 2006 reports out too?]
Unfortunately, I had a hard time finding the information I was looking for in Freddie Mac’s 2006 report. I did find plenty of broad warnings of the sort that might mollify the lawyers and accountants who were asked to sign on, such as this statement on page 56:
Operational risks are inherent in all of our business activities and can become apparent in various ways, including
accounting or operational errors, business interruptions, fraud, failures of the technology used to support our business
activities and other operational challenges from failed or inadequate internal controls. We face a number of significant
operational risks, including material weaknesses and other significant deficiencies in our internal control over financial
reporting. These operational risks may expose us to financial loss, may delay or interfere with our ability to return to and
sustain timely financial reporting, or may result in other adverse consequences.
That ought to cover it, don’t you think? But what I was unable to find were specific numbers for the dollar magnitudes of Freddie’s total notional exposure from its various derivatives and guarantees, or the circumstances under which those liabilities would show up as negative cash flow. For that matter, I did not see an explanation of the specific factors that turned a $2.3 billion positive entry for “non-interest income” in the first half of 2006 into a $1.4 billion loss for 2006:H2 (page 91). Presumably this had something to do with the positions Freddie had staked out through derivative contracts, but what were these and what macro factors were driving the swings? Lower mortgage rates? Higher default rates? Or are these derivatives and their interaction with the rest of the portfolio so complicated that even people at Freddie Mac aren’t sure of the answer?
I also recently came across this March 5 speech by
James Lockhart, who is the Director of OFHEO, the agency with some oversight responsibility for Freddie and Fannie. Lockhart’s slides include the following very interesting graphic:
 |
These numbers imply that the ratio of residential mortgages to GDP increased 50% over the last 15 years, a trend that may have some good economic explanations though it could not continue indefinitely. But mortgage-backed securities issued by Fannie Mae and Freddie Mac doubled as a fraction of GDP, while the ratio of mortgages retained by the GSEs to GDP quintupled. If the growth in the latter two have indeed been fueled by a perceived implicit government guarantee, that raises the possibility that much of this growth would not be justified by economic fundamentals, but may instead have contributed to a socially undesirable level of systemic financial risk.
How much risk? Maybe we’re about to find out.
Technorati Tags: macroeconomics,
Fannie Mae,
Freddie Mac,
Federal Reserve
Notional amounts of derivatives are at Table 21, 22, 23 and discussed at Footnote 12 of the annual report. Guarantees are discussed at Footnote 4. The detail you’ll find there may be less dramatic than you postulate it could be above. An attribution of the quarterly changes in net income can be found within its various press release tables (not included in the annual report, http://www.freddiemac.com/investors/er/pdf/2006fin-tbls_032307.pdf). Spending some time with the report can actually reveal a lot and may be rather anti-climatic.
from the Wayback Machine web.archive.org
.
Fannie Mae website FAQ on CREDIT RISK:
(July 2006):
Are you taking on more credit risk when you reach into the subprime market? How will you manage that?
[RESPONSE] To meet its mission and HUD-mandated housing goals, Fannie Mae does intend to take more credit risk in the future, but on a limited and controlled basis. Using our knowledge of how factors relating to a borrower’s property or their wealth and income position interact with their credit history, the company intends to begin offering credit guarantees on a segment of the subprime market in a way that broadens our participation while managing our credit risk.
But less than a year earlier:
(October 2005):
Are you taking on more credit risk when you reach into the subprime market? How will you manage that?
[RESPONSE] Most of the subprime (or “credit impaired”) loans that we have purchased for our portfolio have credit enhancements that take the credit risk up to the “Triple-A” level. As a consequence, we have very little credit risk on subprime loans in portfolio.
We have so far taken very little credit risk in subprime loans. We do intend to take more in the future, but on a limited and controlled basis. Using our knowledge of how factors related to a borrower’s property or their wealth and income position interact with their credit history, we intend to begin offering credit guarantees on a segment of the credit-impaired market — the so-called “A-minus” segment — which have the best loan quality. We will use our underwriting technology to protect ourselves against losses.
Thanks for the pointer, John. But would you characterize 3/4 of a trillion dollars as anti-climatic? And where can I find the total notional guarantee?
Being a former accountant, I find the $701B retained portfolio — which will certainly be at risk as home sales and prices continue to move downward, and ultimately impacting wherewithal to repay mortgages — offset by only $28B in equity to be quite ‘climatic.’
Freddie will be moving to reorganization quite quickly.
It’s going to be an ugly, bloody mess.
JDH – what would the notional value of a bunch of swaps and swaptions tell you, anyway?
jg – why do you say the exposure is covered only by equity? Do you know for a fact that they don’t have guarantees from other GSEs, mortgage insurance, pool insurance, recourse, etc? I’m pretty sure that you don’t know that for a fact, since they report that they do (and are, in fact, legally required to have credit enhancements on much of their portfolio).
Hi James,
My blogging partner Twist pointed me over here, and your post is certainly interesting. I’ve been worried more about Fannie Mae and their FIN 140 off-balance sheet activity than derivatives, but would certainly like to learn more about Freddie and their situation. Alas I’m not a strong quantitative guy, but since July have gathered a variety of bits and pieces from various sources about F&F on our web site.
Fannie calls the trust funds they use to achieve sale (aka off-balance-sheet) accounting “Qualifying Special Purpose Entities” (QSPEs, like Enron did). WaMu calls them Early Payment Facilities. Do you know what Freddie calls these, and if like Fannie they have “sold” essentially all of their retained portfolio to counter-parties (heaven knows who the counter-parties are)?
Cheers, John McLeod, Halifax, Canada
http://HousingDoom.com
mort_fin, I am trying to get a sense of how big is the impact on markets and how big the problems would be if things go bad.
Check out where James Lockhart went to prep school and college…and what years.
mort_fin, you are absolutely right, that I have no idea what proportion of FM’s loans are covered by guarantees, insurance, etc. All I know is that, in aggregate, marketwide, the notional value of swaps, etc. is many, many multiples that of the underlying obligations, and I feel very comfortable guessing that lots of intermediaries/’insurers’ in the chain pocketed nice fees but did not reserve adequate sums for the forthcoming coverage calls.
Just as the Great Depression resulted in the elimination of multiple level corporations, I will wager that this forthcoming Greater Depression will result in the elimination of multiple swaps of risk.
There is good reason that swaps are described as having a “Notional,” not a Principal, amount. The Principal amount won’t give you any reasonable idea of what could/would be the market impact.
There’s a big difference between the exposure of, say, receiving a fixed rate on $25MM at 5, 6, 7, and 8% and receiving a fixed rate of 6.5% on $100M; the total Notional amount, however, would be the same.
IIRC, FAS 133 requires that the company footnotes its Derivatives exposure. That should be in Footnote 4.
I just don’t understand!!! If FNM is deamed to be “undercapitalized” and it is delinquent in filing 10Qs and 10Ks, and if its clients are suffering, THEN WHY DID THE BOARD OF DIRECTORS RAISE THE DIVIDEND EARLIER THIS MONTH? From their website:
“Fannie Mae Files 2005 10-K
May 2, 2007
The company also announced that it has increased its quarterly common stock dividend to $0.50 per share.”
AND WHY IS THE STOCK MOVING UP SO STEADILY IN THE FACE OF ALL THE RISK?
WHO BUYS THIS STUFF AND WHY?