Scoping the Mortgage Crisis

Includes: FMCC, FNMA, IYF, XLF
by: John Hempton

Why not start with big ideas. How do we get a grip on how big the mortgage crisis is and/or will be?

Lets start at the beginning. In December 2006 the mortgage crisis was but a glimmer in the eye of a few maniac short sellers. (I would like to gloat here but given I predicted it, I made not nearly enough money.)

At that date there were 9,854 billion dollars of mortgages outstanding in the US. (Source - the historical tables in the latest release of the Flow of Funds document at the US Federal Reserve site.)

  • Fannie May (FNM) guaranteed 2526 billion (source: 2006 Fannie Mae annual report).
  • Freddie Mac (FRE) guaranteed 1477 billion (source: 2006 Freddie Mac annual report).
  • Ginnie Mae (ie the US Government) guaranteed 410 billion (source: Ginnie Mae annual).
  • Veterans Affairs (also the US government) guaranteed 203 billion (source: notes to the Veteran Affairs report to congress).

That adds up to $4,616 billion which has a government guarantee or where the loss will wind up being Fannie Mae's or Freddie Mac's (or the government when they bail out those entities).

So there is $5,238 billion to which the private sector is potentially exposed.

So how big could the losses be?

Well let's get really extreme - gargantuan extreme. Suppose 40% of all of these mortgages default - and that the loss given default is 40%. That suggests a maximum (non-GSE, non-government) loss of $838 billion.

It's not going to be that large.

In 2006 the pre-tax profits of the S&P financials grouping were $420 billion - so the losses could be absorbed by two years pre-tax profits. Moreover many of the losses are offshore - and so they would be absorbed by non-S&P pre-tax profits.

All this suggests that the problem is manageable from a systemic perspective.

I ran this analysis past a friend of mine who made $4 billion shorting subprime debt. He said that I understate it because he was shorting stuff to European banks (and AIG!!!) and his gains were their losses. Losers' losses could be larger than the system-wide loss (as he - and some other smarties - have gains).

Another way of looking at this was that there was about $1,200 billion of subprime debt outstanding in December 2006 - and maybe $1.4 trillion of Alt-A (which was just less-than-prime). The losses on the subprime might be 60% default and 50% loss, giving a total default of $360 billion. (That is pretty extreme - a 60% foreclosure rate.) The losses on the Alt A debt are not likely to be much more than 200 billion.

Again you get to a number that is manageable within the pre-tax earnings of the financial system.

What is odd here is that the market is already (at least with respect to secondary pieces) pricing this stuff roughly at this worst case.

A typical sort of pricing is a piece of ALT A originally AAA rated strip priced at 80c on the dollar.

Lets go through the math. It originally had 12% of retained strip protection. The rating agencies thought this was legitimately AAA because it would require 30% defaults and 40% loss given default to eat through that protection. (I couldn't fault the notion it was AAA when written!)

The defaults will be higher than that - but let's suppose that they are 50% with a 50% loss given default. That is utterly extreme. Then the total loss will be 25%. The AAA strip will lose its protection (12%) and its next 13% off the top. But it is priced at a 20% discount. You will make money buying the strip here.

It originally yielded essentially the Treasury rate (it was AAA). However you are buying it at 80% - so it now yields 1.2 times the Treasury rate. You will also get 7% (or more) recovery on this. If the losses are less extreme you will get up to 15% recovery. So all in all, you might get 4-5% more than the Treasury rate.

Oh great, 9-10%.

Its cheap - but hardly exciting.

In the old days it would be money-for-jam. Reason - you would borrow money to buy this stuff. Today's Problem: nobody will lend you money secured by this any more.

So there are forced sellers - and no leveraged buyers. This is what is known as "waves of de-levering". The only buyers are ones with huge excess cash (read Warren Buffett!) and even then they can afford to be selective.

The question: when is it worth selling your liquid and easily priced General Electric (NYSE:GE) stock to buy illiquid but pretty sure to earn you 9% problematic Alt-A formerly AAA rated securities?

When I put it that way - it's pretty clear that the market is mispricing the mortgages - but it will not be me who closes the arbitrage.

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