Capital, almost as good as money

June 12, 2008 | Capital markets, GSEs, Regulation and Reform, Subprime

The great Yogi Berra, whom I’m fond of quoting, upon being asked why he endorsed a product, replied:



“Don’t make that check out to ‘bearer'”


Because they paid me in cash, which is almost as good as money.




For financial institutions, capital is just as good as money, even if it’s not cash – and this matters enormously, because banks are judged sound based on their capital, whereas (like Bear Stearns) they can suddenly go bust when they run out of cash.  Since we care about cash, we need to be alert for capital that isn’t cash, as revealed by a Wall Street Journal article – that, while repeatedly crossing from reporting into editorializing, performs a service with a healthily skeptical focus on the government-sponsored enterprises, Fannie Mae and Freddie Mac:


Fannie Mae and Freddie Mac may soon come under the thumb of a new, beefed-up regulator following a compromise reached last week between the White House and Congress on new housing legislation. Like any new sheriff, this one will want to clean up the town.



Time for some new capital requirements


That means putting Fannie and Freddie on firmer financial footing so they can be strong enough to act when the housing market needs them. The current regulator, James Lockhart, says they are far from that now. In a recent speech, he said that Fannie and Freddie “have continued to be a point of vulnerability for the financial system because they are so highly leveraged relative to their risks.”


Right now, with the huge increases in volume they are experiencing, Fannie Mae and Freddie Mac are almost certainly generating much larger profits from their origination activities.  These may well generate a substantial cushion, but as we’ve seen before, they could be facing large writedowns on the existing book of business, especially the 2007 vintage.


It all gets down to Fannie and Freddie’s balance sheets [which under previous leadership were turbocharged – Ed.] , specifically the amount of capital they have relative to the amount of assets they hold.  Problem is, these balance sheets look something like the Augean Stables, and it would take a financial and political Hercules to clean them out.  



Hercules did it by diverting a river


A look at three of the knottiest areas shows why.


Mirage Capital



Oceans of capital?


Just like banks, Fannie and Freddie are judged by their regulatory capital. But regulatory capital at Fannie and Freddie is a mirage thanks in part to the inclusion of deferred tax assets.  These are essentially losses that can one day be used to offset future tax bills.


To be precise, if a company has tax losses, it doesn’t get a rebate from the Treasury (unless it ‘carries them back by amending the tax return from a previous year), so they can be carried forward and used against future taxable income.  The deferred tax asset represents the estimated savings (losses times projected effective rate, plus unused credits like LIHTCs) – and they go on the balance sheet as a capital, implicitly ‘just as good as cash.’


These assets won’t be much use if Fannie and Freddie need to come up with quick cash.


Some (like LIHTCs) could be sold, although right now the LIHTC market is in a ground-hold.



Not many new syndicates taking off


Banks, for example, only get to count a portion of these assets toward their regulatory capital.


Just another one of the GSEs’ Federally chartered awfully big advantages.


That should also be the case at Fannie and Freddie, especially since those tax assets recently ballooned.


That’s editorializing, not news reporting – but it’s a plausible hypothesis.


At the end of the first quarter, Fannie had deferred tax assets of $17.8 billion, equal to 45% of total shareholders’ equity, while they were $16.6 billion at Freddie, slightly more than [100% of] total equity.


To get to use these assets, which generally have lives of about 20 years, Fannie will need to generate about $50 billion in profit and Freddie about $47 billion. Between 2003 and 2007, Fannie posted net income of $19.7 billion while Freddie’s total profit was $7.4 billion.


If we use those figures as representative, Fannie Mae has a 10-year backlog of deferred tax assets, and Freddie Mac a 25-year backlog.


When it becomes unlikely that a company will use their deferred tax assets, they often write down a portion of them.  Fannie and Freddie have yet to do so.


A Freddie Mac spokesman said, “We feel very comfortable about how we’re operating our business under the current regulatory environment.”  


What else could one say?  “You’re right, we should write these down, thanks for pointing it out”?



Now you mention it, we shoulda done that a long time ago


A Fannie Mae spokesman declined to comment.



That’s the other approach


Lost Losses


The accounting rules say you don’t need to actually post a loss to get a deferred tax asset. Those losses can be unrealized and are accounted for on the balance sheet. But companies can’t delay the inevitable; eventually, unrealized losses must hit profits.



I just realized my losses


Accounting allows for what normal folks think of as indivisible objects to be sliced in pieces.  Here the tax reporting and GAAP reporting are sliced in twain: the GSEs are getting a tax benefit – a loss based on expected writedown of an asset that has not been sold – even as they do not take a hit to capital.


At the end of the first quarter, about $5.4 billion of Fannie’s $9.3 billion in unrealized losses on some debt securities were older than 12 months. Freddie had $13.2 billion of unrealized losses more than 12 months old.  A new regulator should press Fannie and Freddie —


Again, editorializing by the Journal.  I wonder why the Journal couldn’t find a source to say this on the record?



Look, kid, it’s not cub reporters who editorialize, it’s editor, get me?


— to recognize at least a portion of these losses, whose age suggests they are more than temporary.


That, at least, is reasonable deduction.


Doing so would hit profit and reduce regulatory capital. Already some other financial firms, such as American International Group Inc., have begun to recognize such losses.


“Just because all your friends are doing it,” as my mother used to lecture, “does that make it right?”



And if they invested in CDO-squared, would you do that too?


Bad Debt


Another area requiring action is the reserves Fannie and Freddie take against bad loans. These act as a balance-sheet buffer against losses from defaults, and they are a big concern for bank regulators, particularly when defaults are rising.



Bad loan, bad


Now we come to the story’s meat: the risk that the older book of business will sink the profits from the 2008 and future originations.


Past-due loans are soaring at Fannie and Freddie, but it doesn’t look like they have increased loan-loss reserves at a brisk-enough pace.  Freddie, for instance, had $22.8 billion of nonperforming assets at the end of the first quarter, up from $18.5 billion at the end of 2007.


This is worrisome.  I posted about it at the beginning of this year, having spotted a then-little noticed story in Inside Mortgage Finance, published in July, before the credit markets seized up:


Inside the GSEs                               

June 20, 2007


GSE Nonprime MBS Up Among Top Issuers


Does this say that, during the summer of 2007 — a period, we now know, when some of the worst new issues were going on the street — the GSEs were busily buying?


In the wake of the much-publicized pledges by Fannie Mae and Freddie Mac to help out subprime borrowers, a review of the latest data provides a somewhat conflicted story.



I sure you make it clear


The two GSEs have increased their purchases of subprime and Alt A mortgage-backed securities from the top 20 issuers by 13.4% during the first quarter, while purchases from all issuers dropped 3.4%.


Does this say that the GSEs were buying heavily in the first quarter of 2007?


Compared to the first quarter of 2006, GSE purchases from the top 20 issuers are off 10.5% and off 19.2% from all issuers.


Does this say that the issues were already being marked down in summer, 2007, seven months ago?


Remember, financial reporting always lags operations, and it can lag for months, quarters, even years – particularly when it comes to seasoning of loan portfolios and the potential for loss exposure.


Freddie’s loan-loss reserve of $3.9 billion is equivalent to 17.1% of first-quarter nonperforming assets.


Are all the assets classified as ‘non-performing’ actually delinquent (that is, behind on payments)? 



We’re just underperforming, that’s all


Sometimes lenders use a more conservative standard.


Analysts estimate that Fannie’s reserve was equal to about 16% of its past-due loans in the first quarter.


When a standard mortgage goes into delinquency, analysts say lenders should reserve between 20% and 40% of the value of the loan.


In other words, the anonymous recommendation is to presume recovery, net of costs, of between 60% and 80% of loan amount. 


With Fannie and Freddie’s loan-loss reserves apparently below these levels, a new regulator should want more protection against credit problems.


The third bit of direct editorializing – not unjustified, but overt.


A regulator that pursues these kinds of changes, and thereby strengthening Fannie and Freddie, could at least be one positive to emerge from the housing crisis.


I’ve previously posted that catastrophe is a precondition to fundamental financial reform, and the Journal’s editorializing does highlight that the regulatory power of banking on value does not extend automatically to the GSEs, who already have a favored position.


Reform is in order.



Can’t afford to have the GSEs tumble



Comment from Joe Y
Date: July 9, 2008, 1:15 pm

In Fannie and Freddies’ defense, they were under enormous, frankly irresistable, pressure from Congress to drop underwriting criteria for both poorer borrowers and to reward political supporters (as I know first-hand all too well), and I believe Congress will protect them. I’m surprised the magnitude of this hasn’t come out, but maybe that’s one more reason-the most urgent?-why I think they are safe.

Comment from Fat Man
Date: July 9, 2008, 10:57 pm

“putting Fannie and Freddie on firmer financial footing so they can be strong enough to act when the housing market needs them.”

If not now? When?