Fannie Mae's Credit Loss: What's the Real Story?

| About: Fannie Mae (FNMA)

I' ve received numerous Emails asking me to comment on Fannie Mae's fuzzy math and More doubts about Fannie Mae's (FNM) disclosures.


Tanta on Calculated Risk's Blog explains the situation quite well in a very lengthy post entitled Fuzzy Math or Fuzzy Reporter? Following are some snips from Tanta.
On November 15, Peter Eavis of Fortune Magazine published a breathless essay accusing Fannie Mae of having changed the method it uses to calculate its credit loss ratio in the Q3 filing. .... Eavis, moving from a change in presentation to a change in calculation with intent to mislead at the speed of light, says “Uh oh. It’s Enron all over again.” ....

Fannie Mae stock started to tank badly, and Fannie scheduled an analyst conference call for Friday morning to address this one very specific issue in one table in the Q. Fannie Mae explained, among other things, that the item excluded from the credit loss ratio calculation is, actually, included in net charge-offs on the consolidated financial statements. However, for the purpose of this specific metric, the credit loss ratio, fair value write-downs that have not yet produced an actual loss are excluded.

You can listen to the webcast here.

So what did Eavis do, after the conference call and some delving into the credit loss ratio suggested that perhaps he merely misunderstood the math? He wrote a follow-up article on Friday, in which he continues to insist, even after Fannie Mae’s explanation of the issue, that the amount of exclusions from the credit loss ratio (that is, the amount of the fair-value write-downs on repurchased loans that are delinquent but not yet defaulted) is inexplicably large, and that these are forced repurchases, and that this is somehow sinister.

Let me cut through the accounting archana to what I think is the real issue here. Fannie Mae has always had the option to repurchase seriously delinquent loans out of its MBS at par (100% of the unpaid principal balance) plus accrued interest to the payoff date. This returns principal to the investors, so they are made whole. If Fannie Mae can work with the servicer to cure these loans, they become performing loans in Fannie Mae’s portfolio. If they cannot be cured, they are foreclosed, and Fannie Mae shows the charge-off and foreclosure expense on its portfolio’s books.

Now, Fannie also sometimes has the obligation to buy loans out of an MBS pool. But we are—Fannie Mae made this clear both in the footnote to Table 26 of the Q and in the conference call—talking about optional repurchases. Why would Fannie Mae buy nonperforming loans it doesn’t have to buy? Because it has agreed to workout efforts on these loans, including but not necessarily limited to pursuing a modification. Under Fannie Mae MBS rules, worked out loans have to be removed from the pools (and the MBS has to receive par for them, even if their market value is much less than that).

Fannie Mae could avoid these write-downs by failing to exercise its option to buy the loans from the MBS. That would mean Fannie Mae refusing to work out loans with borrowers. Or, to put it another way, the price of Fannie agreeing to work with troubled borrowers is an out-sized hole in the current quarter’s charge-offs, not just because of the loan quality, but because of the total melt-down in the secondary market for nonperforming loans.

The enormous pressure they are under by Congress and the public to modify as many loans as can possibly be saved has been so well-documented in the press that I’m sure they heard about it on Mars. It’s possible that Fannie is too optimistic about the cure rate of these loans. It’s possible that deep inside, they realize they are going to eat huge losses on all this stuff. But they were told in no uncertain terms to buy it out of the pools, take the FV write-down like a big kid, and start working out loans.

Yesterday I spent over two hours rooting through SEC disclosures and listening to a 57-minute conference call trying to independently verify Eavis’s point; today I’ve spent a couple of hours writing this post. I am willing to believe that very few people have the time and the expertise to do what I just did. I therefore feel compelled to share my point of view with the rest of the world, in the interest of a worthwhile public discussion of financial and economic matters, which is the purpose of this blog.

So I didn’t start out with the goal of catching Eavis being a lousy reporter; I started out with the goal of reading about Fannie Mae in a CNN Money article. But I believe that I did discover hyped, misleading, and ignorant reporting, and I believe it is fair to say so in public.
It may not sound like it from the above snips, but if you read her entire post you will see Tanta is no Fannie Mae apologist.

Minyanville's Kevin Depew had this take:
Fannie Mae (FNM) held an investor conference this morning to address accounting questions raised by two recent changes the company announced last Friday, and following an article from Fortune that made the rounds yesterday and which some blamed on the stock plunging 10%.

The stock is down another 5% today, so it would appear the conference call didn't go very well, but why? Last week Fannie Mae reported $670 million in credit losses in the third quarter related to charge-offs recorded when delinquent loans were bought from MBS trusts, or Mortgage-Backed Securities trusts, under an accounting principal known as SOP 03-3.

At issue in the accounting arena is that Fannie Mae says their experience is that the majority of these bad loans don't result in realized losses. How so? Suppose Fannie buys a $100 loan out of trust that is delinquent, which is a common part of their business. They compare their estimate of the loss on the loan (based on zip code data, etc.) to the market-based estimate of the loss and record the lower number. Lately the market numbers have all been substantially lower than the company's estimate, a function of a lack of liquidity and ongoing credit market problems. So say the loan is market valued at $70. Fannie takes a $30 charge up front based on the market estimates. In that way the loss is recognized before it is "realized."

To be fair, many of these recognized losses on these loans are, in fact, recoverable, or in the industry's parlance, many "cure." Where Fannie Mae was hazy on the call today was in disclosing what the company's actual "cure rate" on these bad loans might be. The company, beyond admitting that the "cure rate" is going down, was not specific on what the percentage might be. Fannie says "the majority" cure. But when asked if "majority" means 50-75% or 75% and higher, the company refused to narrow the range.

That leaves an obvious question hanging in the air: is the company being overly optimistic in its assumptions about how many bad loans will stay bad?

Fannie Mae also guided to an expected loss next year ranging from 8 to 10 basis points related to the same recording of charge-offs. And this is where things began to fall apart in the call. Fannie Mae CFO Stephen Swad said, "if there is a 4% national decline in home prices in 2008 and no nationwide recession, we may see a credit loss move into the eight to 10 basis point range."

Fannie Mae, at this point, may be the only institution in America counting on a 4% national decline in housing prices in 2008 and no national recession as the "worst case scenario."
I listened to the Webcast and recommend everyone to do so. If anything, Professor Depew understated the amount of dodging Fannie Mae did on the question on expected cure rates. Fannie Mae also dodged questions about capital reserves on several occasions. On a side note, if you are not reading Professor's Depew's daily dose of Five Things you are missing out on some of the best commentary on the web.

It's important to remember however, that Fannie Mae's hands are tied by GAAP accounting. GAAP requires analysis of what is happening now as opposed to what anyone (including Fannie Mae) thinks will happen in the future.

Thus Tanta is correct that the charge of “Uh oh. It’s Enron all over again.” on this issue is baseless. However, Professor Depew correctly points out that the what if scenario of a 4% decline in housing prices and no recession is hardly a worse case scenario.

My Take
  • A recession is a given.
  • The assumed cure rates by Fannie Mae will not be as good as projected by past history.
  • Housing prices will decline more than 4%.
  • Fannie Mae is way under capitalized and a systemic threat. Oddly enough this was the opinion of the Fed before they abruptly changed their minds in reaction to the credit crunch.
Please consider the Testimony of Secretary John W. Snow Before the U.S. House Financial Services Committee Proposals for Housing GSE Reform on April 13, 2005.
As members of this Committee are aware, the Treasury Secretary has discretion to issue debt in the amount of $2.25 billion to each of Fannie Mae and Freddie Mac and $4 billion to the FHLBs. Some commentators believe that this credit availability reinforces the perception that the Federal government backs the debt obligations of the Enterprises. This perception is false.

More than six out of ten institutions in the banking industry hold as assets GSE debt in excess of 50 percent of their capital. We share the view expressed by Chairman Greenspan and others that the sheer size of the mortgage-based investment portfolios of the GSEs has grown well beyond anything needed in carrying out their housing mission. As Chairman Greenspan has stated:

"… these institutions, if they continue to grow, continue to have the low capital that they have, continue to engage in the dynamic hedging of their portfolios, which they need to do for interest rate risk aversion, … create ever growing potential risks down the road."

Some of this risk can be hedged through the use of derivatives and other risk transfer mechanisms. Nevertheless, the risk does not disappear altogether, and in the event of an unforeseen problem, the GSEs might not have the funds to pay off their debtholders, which could lead to ripple effects throughout our entire financial system. For example, GSE debt is widely held by banks, so that if this debt declined in value, some banks could find their solvency endangered.
Fannie Mae Daily Chart



click on chart for a sharper image

The above chart shows Fannie Mae had issues long before Peter Eavis opened his mouth. The issues I refer to are the cure rate, a recession, and charge-offs. Of course there are lingering derivatives issues as well. Let's not forget the political pressure out on Fannie Mae to "work out" loans. This to me is a moral hazard issue. Fannie Mae is bailing out someone when it takes back those loans at par. Who is going to bail out Fannie Mae when the whole thing blows up?

Fannie Mae is a company that should not exist in the first place. The government has no business sponsoring corporations, promoting housing over rentals, or spewing nonsense about the ownership society. All of the above, in conjunction with the Fed bailing out banks in 2001 by slashing interest rates to 1% is what created the housing bubble.

Allowing Fannie Mae to take on larger loans is not the answer. Fannie Mae should be dissolved. Here is the irony of the situation: The government wants "affordable housing" but is doing everything under the sun to prop up home prices.