Monday, April 04, 2005

More Questions At Fanron

Lending giant Fannie Mae is under new scrutiny , this time in accounting for trusts set up to guarantee the mortgage backed securities it issues. MarketWatch, "Fannie Mae is the guarantor for about $1.4 trillion of MBS held by other investors, Fannie draws a fee for guaranteeing those payments will be made."

This is looking more like Enron every day. "Fannie's regulator said it was examining how the enterprise accounted for trusts as "qualifying special purpose entities. Fannie kept the trusts' assets and liabilities off the corporate balance sheet. If regulators find Fannie should have accounted for those trusts on its balance sheet, it would substantially boost the amount of capital the company must hold." That would drive profits way down.

"The magnitude of accounting problems at the company remains unclear. But Fannie has already estimated that problems identified so far could result in a profit restatement of more than $11 billion. Sources close to the various investigations of the company's accounting say the restatement may be much larger."


At 7:32 AM, Anonymous Anonymous said...

I just heard an interview with David Rosenberg with Merril Lynch. Housing wasn't mentioned, but he is a known RE bear.

He is forecasting the FED to increase interest rates 2 more times, for a final FED rate of 3.25%. This is going to leave the mortgage rate low, maybe 6%.

Guess what ? People aren't pricing houses by their asset value, they are pricing them by their carrying costs. As long as the interest rates stay low, housing prices are going to stay high. If interest rates stay near the current level, I don't think this is going to be a bubble burst.

At 8:43 AM, Anonymous Anonymous said...

Here is another FM article:

Notice that they are concerned with the use of "Special Purpose Entities" that don't appear on the balance sheet. For those not familiar with their history, this is essentially what brought down Enron. Special purpose entities were used to keep debt off the balance sheet.

This could get real ugly real quick.

At 9:52 AM, Blogger John Law said...

so what exactly does this mean? it's all so confusing. do they have to raise cash, by say selling some of the mortgages they hold outright? would they have to buy treasuries? could they just have to stop their business for a little while?

it's all so confusing.

At 11:11 AM, Blogger Ben Jones said...

(what exactly does this mean?)

FNM circumvented the regulations by setting up off-balance sheet entities to hold mortgage guarantees, and if the accounting rules require them to put it back on the BS, the regs will force them to raise capital. Less available cash, less return on equity. So they will probably sell stock, which is dilutive and unload the securities, which harms existing holders. All in all, negative. But the comment that it could be a big number is the stunner.

At 12:21 PM, Anonymous Anonymous said...

Fed is tightening up the money supply:

At 12:24 PM, Anonymous Anonymous said...

Half of everyone surveyed think there is a bubble:

The poker game begins ! The bluff is out ! When will the sell off begin ? The first ones out lock in their capital, the last ones in lose theirs !

I can see husbands and wives arguing. "We just moved here. Why do we have to sell ? I thought you said we were going to be rich ?"

This is getting interesting.

At 12:30 PM, Blogger Ben Jones said...

Many thanks for the links

At 12:51 PM, Anonymous Anonymous said...

FNM could very well be insolvent, just like Enron was.

Banks and mortgage companies have been writing all sorts of wierd real estate financing deals at extremely low spreads. I find it hard to believe that everyone has been making money on these deals and that the risk of failure is "minimal".

I think that it is going to be revealed very shortly that FNM is offside on a lot of things and that it must get onside ASAP. Either that or be insolvent.

To do this, I foresee one of two things happening:

a) Investors or the FED must inject a large amount of capitial.

b) FNM must rapidly pare down its mortgage holdings.

Or both.

Remember that at the same time GM is trying to sell of GMAC, which is also full of mortgage risk.

Do we have the makings of a perfect mortgage portfolio storm brewing ?

Either way, there is going to be a big hit to the US economy, either publicly via the FED or privately via home owners, directly or in directly. Specifically, there is going to be an embarrasment and a drain on liquidity.

I watched Enron come apart very closely and this stinks like Enron. I didn't think it was that bad until I read about the Special Purpose Vehicles today.

When I put the fact that all these extremely low, ARM and interest only financings are floating around and there is considerable turmoil in the treasury and bond markets, I suspect that FNM is/was behind a lot of this.

To me, it smacks of 1987 when junk bonds became a secured investment and suddenly there was no (excess) risk and lots of (potential) upside. The same thing holds here: banks and mortgage companies sign up all these questionable home buyers at absurd amounts and rates and FNM underwrites them, taking all the risk. FNM was making its money on the volume of deals it was doing, probably with very low spreads. Now it is sitting with a portfolio of risky investments with no yield.

I'll bet those special purpose vehicles are loaded with losing mortgage portfolios. I'll also bet that they expected their derivatives to cover the loses, but they aren't because there has been too much volatility in the bond curve. It works great to finance short mortgages when the future yields are even lower, but that isn't the case anymore and Greenspan seems bound and determined that the bond market knows that future rates need to be higher than current rates.

One other thing: right now the losses on a reposessed house are low because they've been appreciating. When the bubble bursts, houses are going to be DEPRECIATING and the repo losses are going to be VERY HIGH. Furthermore, the required decrease in liquidity to get FNM on side may very well TRIGGER the bubble burst.

We've got the makings of a conundrum like you've never seen before: the solution involves the loss of a trillion dollars or so.

I think the Fanron name fits the situation well, except that this one is going to be even bigger.

I'll bet that GSEs are going to be a thing of the past after this gets resolved. I don't think there is any way that the FED can provide unlimited funds to a company at below market rates and not wind up on the losing side. Frankly, I'm surprised that this didn't happen sooner.

At 1:35 PM, Blogger John Law said...

Kurt Eichenwald is probably going to be able to write another book soon...conspiracy of fools II.

this book will probably be 1600 pages considering in some ways most of us are fools in this game.

At 2:11 PM, Anonymous Anonymous said...

There is a ton of information in this about how banks deal with FNM. I like this:

"As of December 31, 2004, the modeled weighted average lives of MSRs related to fixed and adjustable rate loans (including hybrid ARMs) were 4.65 years and 3.02 years, respectively. A decrease of 10 and 20 percent in modeled prepayments would extend the expected weighted average lives for MSRs related to fixed rate loans to 5.01 years and 5.40 years, respectively, and would extend the expected weighted average lives for MSRs related to adjustable rate loans to 3.32 years and 3.68 years, respectively. The expected extension of weighted average lives would increase the value of MSRs by a range of $143 million to $295 million. An increase of 10 and 20 percent in modeled prepayments would reduce the expected weighted average lives for MSRs related to fixed rate loans to 4.38 years and 4.11 years, respectively, and would reduce the expected weighted average lives for MSRs related to adjustable rate loans to 2.78 years and 2.57 years, respectively."

When I was taking finance classes, the common rule of thumb was to eliminate interest risk in financing by matching the finance term to the life of the asset. Apparently today's owners only expect their houses to last 5 years.

There is a lot of interesting information in that page, more than I have time to analyze.

At 3:04 PM, Anonymous Anonymous said...

There is more:

a) the FED is changing the way it sets the interest rates on the treasury bonds. It used to adjust the rate to the current FED rate every 6 months. This would be advantageous to the FED during a period of falling interest rates as the FED wold then pay lower and lower rates.

The FED has just announced that the treasury bond rate will now be set for life at the time of purchase. This would be advantages to the FED during periods of rising interest rates because the bond purchaser would be locked into the low rate present at the time of purchase.

Guess which way interest rates are going to go ? I doubt the FED would do this for just a little rate hike. Get ready for some big interest rates.


b) The Fannie Mae investigation now concerns that it "failed to properly account for thousands of trusts it created whose assets are kept off its balance sheet."

Note the use of THOUSANDS. WOW. This is big. Furthermore, the article says "uses the trusts to issue securities backed by the billions of dollars of home mortgages annually that it buys from lenders and bundles together for resale to investors worldwide."

So who is buying these trusts ? Do they know they are buying an off balance sheet special purpose vehicle ? If they did, should the profit and losses of that vehicle apear on their balance sheet ? After all, one can't make a profit or loss disappear into thin air, or can one ?

Source here:

Greenspan is scheduled to speak at a hearing tomorrow morning. I can't help but wonder if the new special purpose vehicle investigation information leak is designed to prep the market for what he is to say tomorrow.

As far as I am concerned, it was one thing for Enron to have SPV and inaccurate accounting. They were a public company operated by fraudulent people. How did we get into a situation where a GSE is doing the same ? How deep does this go ?

At 9:51 PM, Blogger Mr. Naybob said...

Ben, Great stuff. Keep it up.
I've done a little digging and posted some explanatory stuff for people unfamiliar with the current situation: GSE's Part I, II and III. I also cross referenced your post with additional details on the new investigation.

At 9:08 AM, Anonymous Anonymous said...

I wonder if any bond funds are holding FNM mortgage bonds ? Does anyone know ?

At 11:44 AM, Anonymous Anonymous said...

--Bond funds Mortgage Backed Security--

Virtually all bond funds have them unless specified in the propectus. The key word to look for is "Government Agency" issues. If you want to buy bond funds, then only purchase ones that are limited to treasury bills or notes. I would look for a short duration of 3 years or less so you limit your risk to rising interest rates. Just my opinion though...

At 11:45 AM, Anonymous Anonymous said...

-- Puts on FNM --

What are your thoughts on buying FNM puts? My concern is a government bailout will prop up the price so I have avoided doing this. Any thoughts?


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