Agency Mortgages: Pulling Back the Curtain

Mad props once again to Zerohedge who shone the bright light on Freddie's latest screed.

I'm not going to take from their discussion of The Fed buying up paper at what will (almost certainly) lead to ruinous losses - you can find that there.

Rather, I am going to look at some of the internals from the document published that they didn't focus on.

Specifically, I'm going to go after a couple of graphs.

Let's start with this one (click any for a larger copy):

This seems to show very small declines in home prices. Or does it? The very next graph says....

Wait a second! Now its down ~20%? Hmmmm.... that's more like what everyone would expect Freddie (FRE) to report. Ok, we'll go with that one.

But but but what does this do to the LTV of their portfolio?

I bet you can guess!

That's a very serious problem.

See, Freddie has a lot of loans on their books that are rather old and have a lot of amortization behind them. That is, lots of principal paid down.

But the newer loans have much less principal paid down and in many cases are underwater. This has driven an insane deterioration in actual credit quality of the portfolio as a whole.

In fact that single slide ought to peel your whig back. If it doesn't, these two will:

and immediately following it:

Notice that up until 2007 there were no loans with more than a 100% loan-to-value ratio in their portfolio.

Freddie (and Fannie) detonated because they were operating with an 80:1 leverage ratio, a number that was demonstrably unsound. Regulators, including Lockhart, Treasury and The Fed, allowed not only Freddie and Fannie but also the FHLB system to operate into this environment with deteriorating fundamentals even though as you can see the deterioration that would cause their explosion was evident in 2007. NOTHING WAS DONE ABOUT IT.

There is no solution to this problem folks. These firms have in the neighborhood of five trillion dollars outstanding in either loans or credit guarantees. The Fed has been furiously buying up these securities even though the black letter of The Federal Reserve Act, Section 14, prohibits it and Section 13 only permits loans, not purchases, because private investors can read balance sheets and graphs and know that there is absolutely no way that this sort of credit book deterioration will end anywhere but a great big fat

We are deluding ourselves if we think this will all turn out ok. It will not. The Fed is likely setting on a loss of more than 10% on its "acquisitions" of these securities right now - a loss that exceeds $50 billion dollars in real money. They are playing musical chairs while juggling nitroglycerin and with every month that goes by another bottle gets added to the juggler's load.

The worst part of it is that in 2006 and 2007, as you can see here, the GSEs were buying right into the maw of the deterioration and these securities are now the ones in the most trouble - just as with all the other lenders.

But that's not what should scare you. No, what should scare you is what they bought, especially in 2005 and 2006. Make sure you're sitting down:

You gotta be kidding me.

59% of all loans in their portfolio from 2005 are Option ARMs?

28% of all loans in their portfolio from 2006 are ALT-A (no or reduced documentation of income or assets)?

From this we can figure out what percentage of their loans are likely to explode. That would be the ALT-A and Option ARM loans.

2005 vintage is 14% of the total portfolio, and 59% were Option ARMs or ALT-A, for 10.64% of their total portfolio.

2006 vintage is 14% of the total portfolio and 39% were Option ARMs or ALT-A, for 5.46% of their total portfolio.

That's 16.1% of $1.870 trillion dollars at risk, or three hundred and one billion dollars. If we then assign the loss rates on these notes that are being seen - about 50% on each foreclosure - we wind up with a real loss of more than one hundred and fifty billion dollars.

Fannie Mae (FNM) almost certainly has similar statistics, and has a total book of somewhere around double Freddie's size, meaning that between the two of these organizations there is nearly $1 trillion dollars worth of garbage paper on their books and close to $500 billion in actual loss that will happen.

Folks, there is no possible way we can backstop this and The Federal Reserve along with Congress and Treasury are covering it up!

Ponzi ponzi ponzi ponzi ponzi!

The Fed and Treasury are pretending there is a "recovery" imminent on the economy as a consequence of even-looser credit standards (to banks) and even more debt spending (by government).

It won't and can't work because the inevitable contraction in the economy (and home prices) that must come is simply made worse by the interest expense that comes when the government (or anyone else) borrows and spends forward.

Losses are created when bad loans are made; there is nothing you can do about it after the fact other than choose who takes the loss.

There is no solution to this other than to cut these two organizations loose and let them blow up. Yes, the losses will be horrific. And? There is no other option! We cannot absorb the losses on this portfolio without creating the potential for destruction of the government's funding mechanisms which is exactly what The Fed is trying to shove down the throat of The Taxpayer without a vote of Congress and without telling you, the people of this country!

There is only one way to bring private buyers of this credit back to the table: We must permanently reform what qualifies for a GSE mortgage and set it into law, with criminal penalties for violations. We must require 20% cash down payments, no more than an 80% loan-to-value at origination (that is, no "silent seconds", no games, no BS) and no more than a 36% back-end ratio (or "DTI", that is, "all debt service to income.")

The Fed circle-jerk MBS game is being played precisely because there is no private market for these things any more. Those who bought got burned and everyone understands that the credit quality on the GSE's book is utter and complete garbage.

But The Fed and Treasury programs to "stabilize" the GSEs mathematically will and must fail. Every dollar borrowed by Treasury to prop these institutions up is one that has to be paid back with interest, and thus the economic damage still remains and is in fact added to by the interest cost.

The longer we keep this fraud going between Treasury and The Fed the worst the impact on our economy will be when it unravels - and unravel it will.

It is inevitable.

Did you keep your bomb shelter around after the '50s? You might need it for shelter from this economic storm - the one that all the pundits claim is "over" when in fact we are simply sitting in the eye of a Cat 5 hurricane and the eyewall is bearing down on us at 30 knots.

Don't believe the lies - the math is never wrong.

Comments

[Tack:]

Explain why private funds are being created daily to run around and buy up mortgage paper, including Alt-A, specifically, in many cases? It's because the real performance of mortgage paper, and thereby imputed real value, bears no resemblance to the values assigned by the mark-to-market hysteria.

Many people probably would realize it, but when the Fed stepped in arbitrarily and wiped out FBN/FRE shareholders, FNM, alone, was cashflow positive by over $9 billion per month. There was no liquidity problem, at all, just hysteria over paper solvency -- by the way, the same thing that's wrecked bank values, while they, too, have been increasing cash flows throughout.

As long as most people keep paying their mortgages, and most people do, there won't be any real blowup in cash flows or liquidity, and the only risk is whether a new hysteria on paper values can be created by those with CDS positions hoping for systemic collapse.

And, there's no fundamental reason why home price should or will keep falling perpetually, as one of the effects of the worldwide currency-printing binge is the devluation of fiat currencies and the relative escalation is nominal terms of all hard assets, including homes. That's the time bomb we're actually sitting on.

Those who bet on contraction, deflation and failure will find themselves on the wrong end of the deal, as has happened in every other real estate contraction.

Jun 29 11:43 AM

[Warm_Paw:]

All is not well with Fannie Mae and Freddie Mac.
I believe this route of destruction was Fed created by the fact Alan Greenspan was promoting option ARMS before they imploded.
Is this the Fed's way to prick a bubble?
Did they underestimate the domino effect this would have?
When does a Fed Chief promote any type of mortgage?
Suzy orman was promoting fixed rate mortgages. She was giving sound logical safe practical conservative advice.
Why would Greenspan feel compelled to promote ARM's while he was at the wheel in deciding interest rates?
He's the man that needs to testify to hard questions in front of congress.
Didn't this kind of issue occur with Long Term Capital Management years before, on a smaller scale?
Wouldn't we have learned from that?
Who created Credit Default Swaps and when?
Were they regulated?
The whole down spiral stinks. Is it the crisis that injects trillions into the cash flow so the next round of inflation carries capitalism into the next century? If so, why couldn't we just dump the cash into the existing monetary system? Inflation?
So many questions...
So is this well choreographed?
Are we to emerge chugging along on all cylinders with inflation putting the money values behind us?
Or did globalization and the off shoring of American manufacturing give China and India the next super power potential while the US soon becomes the next third world country?
Texans illegally crossing the border into Mexico in search of work?
Not sure what the powers that be are working toward but this looks like a crap shoot in an alley.
Time to take our lumps and let those that are supposed to fail, get it done so we can rebuild from the ashes.
Time to recognize why protectionism occurred in the first place.

Jun 29 03:13 PM

[Pottermus:]

We, the United States, is screwed.

Government for the people by the people. Not.

Jun 29 04:00 PM

[Karl Denninger:]

BTW before someone else notes it there is a correction to the OptionARM percentages; it reduces the Freddie exposure to some ~80ish billion.

However, this still puts the total loss north of $100 billion on those alone, then we get into all the so-called "prime" that isn't (any file underwritten by computer, where there is no actual verification of documents!)

Jun 29 05:50 PM

[Philip Gvinter:]

Karl,

The amount of trash that FNM and FRE hold is pretty astounding. I agree with you that backstopping their losses by Treasury would be impossible, however that does not seem to be the course of action decided upon by our collective brain trust.

Instead they have decided to allow the Fed, the only entity with a set of books which is not audited to backstop the losses. The Fed will buy up the worthless garbage. The garbage will underperform. The Fed will not report the full scope of the underperformance. The system will remain intact. The price for this is an aversion of deflation and the enrichment of those who perpetrated the scheme. While this is morally reprihensible it is in some ways the least painful course of action from a systemic point of view. The creditors for FNM/FRE are protected. No truly new money is created as the old money which only existed for a temporary period of time is re-created. The inflationary effect will be significant but not uncontrolable. The integrity of the system will remain nonexistent but this lack of integrity will be brought more to light....but not too much more.

I am not a huge fan of this course of action but can think of no other. If we cut off access to reasonable (low down payment but low debt ratio) credit than the housing market will plunge another 40% and the entire global financial system will infact melt down. This is not a superior solution. We do need to gradually raise lending standards but for now FNM/FRE pricing makes it such that any loan with less than 20% down goes FHA. The loans that do go the the GSEs have overly high DTIs (up to 50 rather than the more desirable 33-38 range) and do not ask for sufficient asset reserves (should be at least 12 months but is typically only 2) but are still far better than the loans which lead to the bubble. FHA underwriting standards are overly lax but these lax standards are all that stand between property prices and the abyss. The price to rent ratios and price to median income ratios need to come back in line but that cannot be done overnight. This must be a careful and gradual approach.

Jun 29 09:30 PM