Wednesday, November 21, 2007

Freddie Mac: We feared the worst

There is an old Wall Street saying: Be fearful when others are greedy and greedy when others are fearful. Sure seems like the the world is increasingly fearful in the investment-grade credit market. Of course, what makes following the cliche so difficult is that the fear is always with good reason. We sure as hell have good reason to be fearful right now.

Freddie Mac's fear inducing $2 billion loss, which sent the company's stock tumbling 30% in a single day is just the latest example. Worth noting that Freddie's writedowns, and in fact almost all of the big bank's write downs, have been marks to market. As opposed to actual cash losses.

So what does this mean? Well, in almost all cases, mark to market is an estimation, not a "real" market. To see what I mean, read this exchange between a Bank of America analyst and Freddie Mac management. (Hat tip to an anonymous commenter). The analyst, Robert Lacoursiere, correctly points out that when FRE asks for marks on loans they've bought out of MBS pools, it really isn't an actual security being valued. Nor does FRE have any intention of selling the loans. The Wall Street traders helping FRE value these things know that, which may influence their valuation.

For what its worth, I think what Lacoursiere was driving at was a little different than what Greenberg and his commenters focused on. I think Lacoursiere was trying to ask why FRE didn't use a more "normal" valuation method, like book value less a loss provision. FRE seemed to respond that they were advised to take a more conservative approach. Lacoursiere then asked why the same banks and brokers valuing Freddie's positions weren't using the same valuation methodology themselves. To which Freddie's management obviously had no comment.

Anyway, so back to how bad it is at Freddie. Marking your positions down is only a first step in eventually realizing a loss. Let's take a normal bond portfolio as a comparison. Back in September, it was possible to buy Countrywide bonds maturing in December at $95. Which means that you would earn something like a 25% annualized yield for holding those bonds if indeed CFC pays those bonds off in a few days. Let's say you are a PM who bought those bonds at par in August. In September, you would have "written down" the position by 5 points. But of course, if the company pays the bonds off in December, your portfolio is net-net no different.

Switching back to Freddie, what they are trying to value is loans they've bought out of MBS pools because they've become delinquent. This is where Freddie earns their guarantee premium. Anyway, you can imagine that the "market" for loans already delinquent is pretty ugly right now. Hell, the market for prime loans jumbo loans with no delinquencies is shit right now, Lord only knows what you could get for loans already delinquent.

Now, maybe Freddie thinks they can recover value from the delinquent loan portfolio much better than the market is giving them credit for. And by God, maybe that's true. Regardless, the only responsible thing for Freddie to do is to write down the loans to whatever the market would bear for these loans right now. Again, consider my CFC short-term bond example. Would it be responsible for the PM to tell his clients he's valued the bond at par if the market will only pay $95? Of course not. Doesn't matter if the PM is sure CFC will pay the bonds off. You "write down" the position to 95 this month and if it does indeed pay off, then you wind up with one bad month and one good month. But two honest months.

FRE will experience the same thing. If they can indeed recover a decent amount from their delinquent loan portfolio, then future quarters will see improved ROA. If not, then not. Bear in mind that Freddie Mac and Fannie Mae both require full documentation of income as well as a host of other qualifications. So FRE (and FNM)'s portfolio looks a lot better than, say, CFC or Washington Mutual. And it looks a HELL of a lot better than Citi's ABS CDO portfolio.

Anyway, so Freddie is going to have to raise capital. The market is expecting a preferred stock sale. If the market believes that FRE can indeed manage through this, and that they can indeed recover a fair amount from these written down loans, then they will be successful at raising the cash. Unfortunately for FRE shareholders, the cost of raising capital right now is extremely high, and FRE will be continue paying this cost for a long time. A long time.

Disclosure: No stock position in Freddie Mac or Fannie Mae. Large amount of Agency-backed debt (fortunately underweight, however) as well as Agency-backed MBS.


Anonymous said...

Only a monk in the 7th century toiling constantly with the light of a single candle every day of the year could find a molecule (I know, molecules weren't invented then) of hope in this post.

My translation of the post:

Theoretically, things might get better for the GSE's. The banks? Not so much.

I realize that is probably not your position, but the post reads that way.

Brian said...

Can you make any comments on how Freddie's earnings have impacted the market for agency paper? Aside from wider spreads, I can imagine there were a whole raft of people doing quality spreads between subprime and agency paper. What are the practical ramifications of this in the debt market?

Accrued Interest said...

Agency paper is a good bit wider, but still tighter than anything else other than Treasuries. I'd say that the market is not putting a serious probability on either getting into permanent trouble.

Odds are good that the Federal Government would work out some kind of equity infusion if it really came to that. I'd say a street-based bailout would be the first idea. You'd see all the big banks and dealers put up equity cash to keep either/both GSE's afloat. There's too much at stake for them to just let the GSE's fail.

Besides, I don't doubt that the GSE's have enough performing assets that they can get through this, even without an infusion. The capital infusion would be necessary to ensure the investing public continues to believe in the GSE's as going concerns.

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