Demystifying the GSE's Fannie Mae and Freddie Mac

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lendingmaestro_IHB

lendingmaestro_IHB

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<p>I thought it was a good time to discuss our friendly government sponsored entities, Fannie Mae (FNMA) and Freddie Mac (FHLMC). After seeing Freddie's stock plunge almost 30% today, and the fact that every major bank is feverishly changing their business model to originate conforming loans, I'd like to shed some light on exactly the type of loans they are buying. As you may gather from the snippets below, many conforming loans may actually be worse than loans bought by private investors. Your input and experience is appreciated.</p>

<p>1.) Fannie and Freddie don't buy sub prime loans. This is 100% false. Up until recently, you could get stated income loans approved for borrowers in the 500 FICO range. As of right now they are still purchasing sub prime loans if they are full-doc and 70% LTV or less. I personally know people who make lots of money, but can't pay their bills, so their full-doc loan is still very sub prime.</p>

<p>2.) Fannie and Freddie offer 5, 7, and 10 year ARMS. They also offer Interest only products. Again, I personally know folks who got a 5/1 ARM @ 4.875% in 2003 who cannot afford their new payments at today's market rates. Both entities still offer stated income programs.</p>

<p>3.) The DTI threshold for many programs is 65%. That is not a typo. 65%. Most private investors would only purchase loans with a DTI of 50%.</p>

<p>4.) Fast Forward Documentation. This is a big one that may get them in trouble in the future if Atty Gen Cuomo keeps up his rampage. If you have High FICOS and are @ 75% or less LTV you may qualify for fast forward documentation. Sometimes this will require employment verification WITHOUT income verification. Sometimes the borrower will need to provide a pay stub and NO W2. Pay stubs can easily be forged, and it is not a legal document like a W2. Most Fast forward documentation however allows employment and income to be TOTALLY WAIVED. The borrower still gets a full-doc rate, and the investor gets sucked into buying a AAA FNMA or AAA FHLMC Bond!! I personally have seen loans approved where the borrower was unemployed, but the fake employment info entered on the 1003 was not verified.</p>

<p>In many ways, Fannie Mae and Freddie Mac have lower underwriting standards than most private investors. It will be interesting to see how this plays out....</p>

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Wow, I did not realize they were buying so much crap. Throughout all of this debacle, I have been relatively unconcerned about a government bailout because I was under the impression it was mostly private investors who purchased the detritus. If this is as bad as you outline above, we are in for a massive government bailout similar to the RTC.
 
<p>So what does this mean? That Fannie and Freddie are not different that Citibank or WaMu? </p>

<p>Also, there was a blurb in an article in which Freddie asked its regulators to go below the 30% asset limit but was denied. What does that mean? Is it a serious issue if they fall under the 30 percent limit?</p>
 
Even though GSE funded loans are not guaranteed by the gov't, I believe that a feeling of potential government bailout is fostered at Freddie and Fannie. Their shareholders probably hold this illusion to be true as well.
 
<em>Also, there was a blurb in an article in which Freddie asked its regulators to go below the 30% asset limit but was denied. What does that mean? Is it a serious issue if they fall under the 30 percent limit?





</em>Well... You brought it up, so here you go. The amount of assets they have are now less than the debt they have. They need the assets at 30% or they could require a bailout. Now, this is where a gray area comes in. <a href="http://calculatedrisk.blogspot.com/2007/11/fannie-maes-credit-loss-ratio-fuzzy.html">Tanta covered this issue on Fannie Mae this weekend</a>. As Tanta normally is, the post is rather detailed. So, I will do a Tantalite version. First here is a snippet from Freddie today:





<em>Also included in other non-interest expense were losses of <strong>$483 million on loans purchased out of PC pools</strong>, compared to losses of $30 million in the third quarter of 2006, largely due to an increase in the volume, and a decline in the <strong>estimated fair value</strong>, of non-performing loans purchased out of PC pools during the quarter. During the third quarter of 2007, the company recognized <strong>$58 million in net interest income on re-performing loans</strong> previously purchased and <strong>$109 million in other non-interest income associated with the recapture of previously recognized market value losses on purchased loans due to borrower payments or higher realized loan foreclosure values.





</strong></em>That $483 million loss is not a realized loss, but the estimated loss of the fair market value of the loans. For example: Freddie and Fannie have to buy the loans for what they are, not what they are "worth". So, if they had to buy $1bil in loans back, that trade 51.7 cents on the dollar (what they are "worth" $517mil), they would have that $483mil unrealized loss. They need the loss reserves to cover for these unrealized losses, which adds to the asset issue. All they are doing is marking to market the loans, and not marking to myth. As you can see, they made money from the re-performing loans and the realized value on the previously unrealized losses. If they can get back half $241.5mil of that $483mil, then they would have $241.5mil back in value and $241.5mil back from the loss reserves.





They also have unrealized losses on their swaps and other hedging tools. That is a whole other story, but still they are not real losses, at least not yet.





I'm not saying things are all rosy over at Freddie and Fannie, but there is a major flaw when reporters write stories they know nothing about. If you don't know how loss reserves work, and the difference between a realized loss and an unrealized loss, then don't write about it.
 
Well stock prices are partially based on the market value of the company's assets/liabilities, so unrealized losses are still losses in my book. Given the dramatic fall in share price, I'd say it matters to investors as well. These 2 companies sell mortgage backed bonds to the same people private investors do. How will the buyers of FNMA and FHLMC bonds react to this? They'll probably command higher premiums, which will eventually make its way down to the borrower in the form of higher interest rates.
 
<em>"They'll probably command higher premiums, which will eventually make its way down to the borrower in the form of higher interest rates."</em>





That is the chain reaction I see coming. Add to that the premium required to compensate the lender for increased inflation, and mortgage interest rates will almost certainly rise.
 
<em>These 2 companies sell mortgage backed bonds to the same people private investors do.





</em>This is true, but when they buy the crap loans back at par, they keep them on their books and not re-sell them. It is one of the "safety" features of their MBS pools.





<em>How will the buyers of FNMA and FHLMC bonds react to this?





</em>At least today they didn't move much. We will see what happens after the holiday. It could make investors demand a higher return for the risk.


<em>





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WOW! and to think, I was looking on wiki to learn more about Fannie and Freddie today. You guys are taking this to another level.

Thanks! Just wanted to let you people know others are learning from this...
 
<p>After these revelations, the solution is obvious.</p>

<p>Fannie and Freddie are being far to restrictive in thier lending. They need to remove the caps and really get after it.</p>

<p>[/scarcasm]</p>
 
<p>I am verrry pissed at myself for not seeing right through the crap on Fannie and Freddie. My friend and I were discussing them a few weeks back so I did a few hours of research. Lots of places I looked were saying how little subprime exposure they had and I didn't act. I figured much better off with some of the bigger players or waiting for them to recover to jump back in. Well they sure never recovered and it would have been a lucritive ride down. DOH!!!! At least my SKF and SRS are up around 25%. I am going to keep a tight leash on them though and might trade them through the coming false hopes...</p>

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Fannie Mae used to completely waste their implied government subsidy on lobbying programs to ACORN and other community groups and Democratic political activity. Now DC house prices can be marked downwards as all the stock options in Fannie Mae and Freddie Mac become wallpaper. =3 I talked to someone who is on the inside at Fannie Mae and their estimates of foreclosed houses were just not plausible. I would be delighted to see both fail before Hillary can bail them out. My belief has always been that the government should not be involved in subsidizing housing through either the mortgage interest deduction or the GSEs. Regretfully F&F will be bailed out ><





I will love to see the look on peoples faces they discover "Ohh No Fannie Mae Foundations pledges don't exist anymore!" "I thought we were supposed to be paid for being involved with Rainbow/PUSH forever!"
 
sre - I wouldn't be too hard on myself if I were you. Fannie is a tough short. The stock barely moved the whole time they were not reporting and their CEO was being ousted. And they have that implied government backing thing going. There are easier shorts.
 
<p>Who are you looking at? </p>

<p>Short term I think that the financials may be oversold and may recover leading up into the rate cut. I put 5% stops on my SRS and SKF for now. I was looking at MAS, who supplies builders and home dept, was looking at Carmax until I saw Warrent Buffet just bought a chunk, and am going to watch Mastercard through years end for entry. Solar stocks are also really heated and I think there could be a pullback if the broader market rallies. I thought it was a good rally when I had STP earlier this year and now its way higher. </p>
 
SRE, you may want to research MA some more. They don't hold loans, they are a processing business. So if your thesis is based on people defaulting on credit card debt, you are aiming at the wrong target.
 
<p>sre - Have to agree with WINEX on MA. I heard the same thing on "Fast Money" of all places, but it makes sense.</p>

<p>I presently have puts on DSL, MER, MS, WM, KLAC, SNDK, RYL, BSC, C, COF, RIMM, and LEH. I am no longer short as I closed my level four account. I am of the opinion that if the brokerage goes into receivership, anyone with a margin account may not see their funds for years, if at all, so I am sticking with puts right now.</p>

<p>I agree that the financials are oversold, which if I was short means I would just tighten my stops and watch to see if they move to way oversold. It seems very possible at some point. But, given that I am long puts and the premiums are mostly eaten through, I will probably sell them today. My dad likes to say that he never lost money by taking a profit or selling too early.</p>

<p>I am long precious metals and energy and pm stocks. Nothing else. My perception is that there is alot of risk being long right now.</p>
 
I realize, my thinking is that there will be a run up in the stock around this holiday season from more heavy use of plastic. Next year after the spending tapers off may be a good time to evaluate. For a more direct play I am looking at JP Morgan/Chase and Citi. The problem is I have been telling myself that things will pick up for a few days and ill get in short but it sure has not happened in the last few sessions. Lets see how things going leading up to the interest rate decision but Im definately going to be watching my shorts for trading oppurtunities then if a rally occurs, short more sectors in my IRA with proshares.
 
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