FHFA's DeMarco Speaks. Remarks Offer Little Room for Optimism

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Includes: AIG, FMCC, FNMA
by: Bruce Krasting

FHFA’s Acting Director Edward DeMarco provided written testimony to the Senate yesterday. I would give his presentation a B+. There is little room for optimism in this story. Mr. DeMarco did not gloss that fact over. A few snippets from that speech:

  • From July 2007 through the first half of 2009—combined losses at Fannie Mae (FNM) and Freddie Mac (FRE) totaled $165 billion. In the first half of 2009, Fannie Mae and Freddie Mac together reported net losses of $47 billion.
  • Since the establishment of the conservatorships, the combined losses at the two Enterprises depleted all their capital and required them to draw $96 billion. The combined support from the federal government exceeds $1 trillion.
  • The short-term outlook for the Enterprises remains troubled and likely will require additional draws under the Senior Preferred Stock Purchase Agreements.

That’s funny; I thought things were going so well. From the WSJ 8/8/2009:
Some random comments on credit conditions:

  • Among subprime adjustable-rate mortgages, nearly 40 percent are seriously delinquent.

We really ought to string someone up over this number. A 40% default rate is not bad judgment. It is a crime. It is what kicked us over the top.

  • We remain concerned and recognize the risk associated with increasing numbers of seriously delinquent loans and higher forecasted foreclosures. In particular, we are concerned with the continued increase in serious delinquency rates, even among prime mortgages.

Read this to mean, “The next shoe to drop will be prime mortgages.” It was always perceived that prime mortgages were money good. They are not.

On the issue of REO (real estate owned from repo/default)

  • Currently the Enterprises are managing a real estate owned (REO) inventory of almost 100,000 properties, a number expected to grow.

The government can’t sell this crap. If they did, it would just tank the RE market and cause more Prime defaults. Uncle Sam is going into the rental business big time. But that does not look too promising either. Some sobering thoughts on that market:

  • As of mid- year 2009, rental vacancy rates hit their highest level since the U.S. Census Bureau began tracking vacancy rates in the 1950s.

That does not sound like a plus for CRE either.

There are obvious problems at the FHLB’s. Do these words trouble you?

  • The most important financial development among the FHLBanks in 2009 is the deterioration of the PLS portfolios held by the FHLBanks.

How big a problem is this? Big. I smell bailout. The question that must be asked and answered is, “Why were the FHLBs buying private label mortgages? What were the rules on that? Someone made out big on the sale of those securities.

  • Total retained earnings were $6 billion, but negative accumulated other comprehensive income (AOCI) exceeded retained earnings at the six FHLBanks with the greatest PLS exposure.

A good number of people were paid a fair amount of money to come up with the term AOCI. What would be a better description of "Negative Accumulated Other Comprehensive Income"? The word "loss"comes to mind.

You have to give DeMarco some credit for the following. The accountants may be lying but he is not:

  • The decline in the carrying value reflects impairment charges of almost $8.2 billion, however, a change in accounting rules resulted in only $953 million charged against income.

On the issue of interest rate risk management at Fannie and Freddie DeMarco gives a ‘tell’.

  • The Enterprises’ investments in mortgage assets expose them to market risk. Given the uncertainties in the marketplace, managing market risk continues to be a challenge.

There was a spike in interest rates earlier this year. At that time someone did very big amounts of ‘duration’ trades. I believed then that it was the Agencies puking it out at the bottom of the market. I think Demarco confirmed it. Look for big derivative losses in the third and fourth Q’s for both F/F.

On the complicated issue of mortgage insurance (PMI) comes this from DeMarco:

  • The Enterprises will refinance those mortgages (ones in default) without requiring additional private mortgage insurance. If there already is mortgage insurance on the existing mortgage, that coverage will carry forward to the new mortgage.

This is a flat out subsidy for the PMI providers. When a loan goes into default and a loss is realized the insurance that is there should cover a significant portion of the loss. By rolling the loans the loss is avoided, and so is the necessity to pay up on the claim. This is keeping the PMI folks alive and well. One of the larger players in this space is AIG. We wouldn’t want to do anything that would hurt them would we?

The following warmed my heart. Finally someone is owning up to how we got into this mess:

  • The markets relied upon an implicit government guarantee of Enterprise securities.

Who created and sold the lie that the US Government was behind $5.3 trillion in dodgy MBS paper? It was a few dozen politicians, folks at Treasury, the entire mortgage industry, most of Wall Street and everyone at Fannie and Freddie.

Finally, a confirmation from DeMarco that there is a plan coming. Of interest is that the timetable seems to have been accelerated. This was supposed to be a March 2010 issue. The Director suggests it may be here in time for Santa. I can’t wait.

  • I know the Administration has committed to addressing (the GSE’s) in the coming months.