Yesterday, wondering who might be next in the writedown game, I hauled out a June, 2007 story from Inside Mortgage Finance that reads much more scarily now than it did back when it was first published.

Back when the only thing we had to worry about was The Bomb

Who’s next?

Yesterday we saw that the GSEs were active buyers of subprime and Alt-A mortgages in 2007.  Why were they doing this?

Certainly, the two GSEs continue a delicate balancing act between their housing mission and the need for shareholder return. At the same time, they have to respond to the changes in the marketplace while still having to contend with temporary portfolio caps from their regulator, the Office of Federal Housing Enterprise Oversight.

“While they are interested in growing their portfolios, OFHEO is not interested in letting them grow,” said Eileen Fahey, a managing director in Fitch’s financial institutions group.  “Given the market over the past two years, they are interested in changing their portfolios and assuming new risks. They’ve moved away from the management of interest rate risk as their primary method of earning money and are shifting more toward credit risk.”

Read with the benefit of hindsight, that sentence is especially frightening.

Is that who you’ve been lending to?

Back two years ago, as I posted at great length, Fannie and Freddie took advantage of the yield curve to turbocharge their balance sheets and make a ton of money on the spread between long-term rates and short-term rates.

Now that we have a basic framework for assessing secondary mortgage market players, how might a GSE turbocharge its earnings?   

Alien not included. 

By exploiting the combination of (a) Federal implicit guarantee and ‘moral hazard’ — the managers’ ability to maximize use of the GSEs’ implicit Federal guarantee, and (b) Yield curve.  That short-term rates are usually lower than long-term fixed rates.

As I posted in my translation (emphasis added) of former Federal Reserve Chairman Alan Greenspan:  

Fannie Mae (Fannie) and Freddie Mac (Freddie) essentially run two lines of business:

1.       Securitization of mortgage credit,

2.       Holding of mortgage and other assets for investment purposes.

[They can only do the second by borrowing on their own credit. — Ed.] 

The first line of business provides substantial benefits for affordable housing through the process of using credit guarantees to turn mortgages into marketable securities that trade in public debt markets.  This process creates a wide variety of liquidity benefits, some of which flow to homeowners and mortgage originators. 

By matching maturities (colloquially called match-funding), an issuer like Fannie Mae can keep itself out of prepayment risk, and the securities issue can be free-standing, with no open-ended risks to the issuer; such an issue is spoken of as ‘off balance sheet.’   Naturally, securities buyers who know they could have their securities called any time interest rates drop will want a higher premium. 

More, gimme more yield

When the yield curve is positive (as it normally is), lending long and borrowing short manufactures spread.  It also mismatches maturities.  In the conventional environment, where the bond buyers are looking at the issuer’s creditworthiness, mismatching of maturities are penalized in rate; in effect, those who lend short cast a cynical eye over the borrower’s balance sheet, leverage, exposure, and management practices.  

A conventional borrower’s turbocharger has an automatic brake, but the GSEs, with their awfully big advantages including the implicit Federal guarantee, have no brakes at all, as Mr. Greenspan put it succinctly (full text in .pdf):  

Under normal circumstances, GSEs are able to easily maintain and grow their large portfolios of mortgage and non-mortgage assets without the significant market checks or balances faced by other publicly traded financial institutions. 

Some entities need to be scrutinized

A private company trying this trick would be tested for its ability to cover an adverse swing.  Since the GSEs are perceived to be protected by Congress, this doesn’t happen, so the market doesn’t charge the GSEs a premium, and hence the market doesn’t check their balance sheet growth.

These large portfolios, while enriching GSE shareholders, do not meaningfully benefit homeowners and do not facilitate secondary market liquidity. 

The rate spread compression (cheaper loans) occurs at origination and initial securitization.  Buying and selling existing portfolios doesn’t help the consumer.  It does make Fannie Mae a ton of money, and it puts taxpayers at risk:

They do add systemic risk to our financial system, which normal market forces are unable to resolve.

“And risk is bad.”

In 2005 and 2006, Congress realized how risky the GSEs’ balance-sheet turbocharging had been, and how lucky we had been with the systemic risk Mr. Greenspan referenced.  OFHEO put severe balance sheet clamps on the GSEs, and thus took them out of the turbocharging business.  That meant the GSEs had to replace their turbocharged earnings with something else.  Now let’s hear the June, 2007 sentence again:

“They’ve moved away from the management of interest rate risk as their primary method of earning money and are shifting more toward credit risk.”

Credit risk, for those of you unfamiliar with the jargon, is the risk that borrowers will default. 

And that the collateral’s no good

Translation: To replace the yield spread they were making on mismatched maturities, the GSEs have bought higher-yielding loans from less creditworthy borrowers.

Oh, great — just the thing we want them to be doing in the first quarter of 2007!

That’s just great, really great
 

“But what they can buy in terms of volume is restricted, so they are doing a balancing act of buying and selling.”
 

Translation: They sold lower-yielding higher-credit stuff and bought higher-yielding lower-credit stuff.
 

Double great.
 

Insanely great, in fact
 

Will the GSEs look more toward AA-rated securities going forward, in a bid to boost profitability?
 

“In Freddie’s case, in their year-end 2006 financials, they disclosed that 96% of their private label securities were AAA-rated, so they obviously bought some that are not AAA-rated, 4%, and that’s double from a year ago,” said Moody’s Harris.
 

Ordinarily, restricting an investor from buying other than AAA would mean you were safe.  
 

For Fannie, it’s a different story. In the annual report that OFHEO submitted to Congress in March, the GSE’s regulator said it was restricting Fannie’s ability to get involved in private label securities to anything other than AAA until certain controls have been put in place, and no timetable was mentioned.
 

That was when an AAA rating meant something. 
 

Luxembourg is next to go
And, who knows, maybe Monaco.
Who’s next, who’s next, who’s next?
 

Now we discover that the rating agencies, whose fee structure put them in a symbiotic relationship with issuers, were giving AAA ratings to lots of synthetic and structured securities, and has downgraded them in huge steps, in vast swathes.  How much of what the GSEs bought with an AAA label is now something else? 

As things age, they can get Rotten 

Officials at both GSEs declined to comment on their portfolio buying strategies.

Meanwhile, Wall Street analysts and investors hope the progress both Fannie and Freddie are making towards a return to timely financial reporting puts them closer to the day OFHEO removes its 30% capital surplus requirement.

But some analysts believe that is likely to happen sooner for Freddie than Fannie, since OFHEO seems to be more concerned about Fannie’s internal controls than Freddie’s. 

As I wrote only two months ago, managed earnings were much more fun: 

Back in the good old days,
 

“All you gotta do is — act naturally!”

Fannie Mae and Freddie Mac aggressively managed their earnings, keeping unrealized gains and losses in reserve so they could turbocharge the balance sheet and deliver earnings that matched estimates with heartwarming accuracy, and maximizing their seven- and eight-figure executive bonuses.
 

We must be good if we hit it every time

Those days are over.  Between new reporting rules, accounting scandals, and pending strengthened oversight legislation, the two GSEs now have to report fluctuations in their earnings not just from realized gains and losses (that is, mortgages sold or foreclosed), but also unrealized (changes in inherent value resulting from market factors, chiefly payment performance), and the results are not pretty.  As reported last week by CNNMoney.com:
 

Freddie Mac scrambles for cash
 

 
As of January 21, the GSEs haven’t reported their fourth-quarter earnings yet.  
 

All the world sees in tune on a spring afternoon
When we’re poisoning pigeons in the park!
 

Who’s next?

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One of us has got to lose

Brokers know that the key to a buyer’s wallet is his heart, not his head; and buyers equally know that if they view through the eyes of love, they will overpay.  So buyers always want to know before they look, and with the internet, they can do something about it, as illustrated by this New York Times article:

A FEW years ago, people advertising homes on the Internet were racing to employ the latest gimmicks: 360-degree photographs to show off spacious living rooms, mortgage calculators to pinpoint monthly carrying costs, even videos of agents to talk about a home’s attributes.

The house Nancy and I currently occupy owes much to that technology, for it was listed via a 360 walkthrough.  Long before Nancy ever revealed herself to the prospective seller, she had toured the place virtually in detail — and, being the Careful Shopper, drawn estimated floor plans.

By cutting search costs, the internet widens markets even as it educates (and therefore empowers) consumers.  So that’s good, but the Web’s greatest use is in information, and the purest information is in numbers.

Today, companies and brokers are focusing less on toys and are offering something more straightforward: numbers. This detailed information — be it local home values, neighborhood amenities or broader market conditions — is part of a trend to attract consumers by offering data they cannot find easily elsewhere, or could once get only from real estate agents.

Numbers are one of humanity’s great inventions [Or discoveries; one can argue that mathematics exists independent of reality --Ed.], for they allow straight-up paired comparison.

Who’s better, Hamilton or Jackson?

Judge them not by their profiles.

Maisha Cannon, who recently sold her home in Paramount, Calif., first contacted Mike Rode of Keller Williams Realty, who e-mailed her back with detailed data about recent sales trends in her market.

Ms. Cannon, a 29-year-old recruiter for the University of Southern California, said Mr. Rode had accessed the data through a new tool for brokers called Market Snapshot — which was an improvement over traditional packets of comparable properties that other brokers provide.

A sample market snapshot

“The chart and graphs were all in the e-mail,” she said. “Someone else might send you a general e-mail and a spiel.”

Do signs point to Yes?

Spiel, from the German for game — an apt description of the broker’s tactics. 

All I can see are my guys, not the opponent’s guys!

When she interviewed agents to decide with whom to list the property, she used the information from Mr. Rode to see if the other agents were on target. Ultimately, she listed the property with Mr. Rode, and the sale price tracked with the data he sent her.

Data lets the customer interview the expert on even terms; for customers who suffer from the only-once phenomenon, this can be the Sword of Achilles to find the righteous woman. 

Offering packages of detailed data is becoming a new method for brokers to build their clientele and a way for general Web sites to feed consumers’ interests. Last month, the search engine Yahoo entered a partnership with a nonprofit site named Greatschools.net to offer buyers detailed data to compare schools.

“In the past, people would, say, send a pumpkin at Thanksgiving or send a calendar,” said Errol Samuelson, president of Top Producer Systems, the company that produces Market Snapshot as a division of Move.com, which owns several large real estate and housing sites like Realtor.com. “Our perspective is, if you provide real information instead of another refrigerator magnet, you set up the foundation for a relationship.”

Ignorance is a hazardous substance

Of course, the explosion of detailed real estate data online has produced confusion as well.

For example, with the popular house valuation Web sites — including Zillow.com and Trulia.com — the results on values for a half-million-dollar house can range from $400,000 to more than $600,000.

That’s just a Hubble-telescope problem — focus comes with use.  More data, better estimates.

Perception floating in space, waiting to be pointed the right way

Even if an innovative product is imperfect, it beats Nothing, so the only reliable trump to bad data is better data:

After the start of Zillow.com, a handful of sites cropped up offering similar services.

Within a month, even the giant Realtor.com, which in recent years had not offered the sale prices of comparable listings online, had a new feature on its front page that gave consumers a starting point to assess their property values.

Once information is cracked, you cannot uncrack it.

How you gonna keep ‘em from opening wider?

“If you tell a house seller that a home value is preordained, the home seller is not going to seek someone to get the best price,” said [Allan Dalton, president and chief executive of Realtor.com].  “We represent both the homes and the professional. At the end of the day, people need to have expert advice.”

Numbers are not reality; numbers are the idealization of reality.  In the real world, there is always a place for judgment.  But though you get a diagnosis from your doctor, he starts by looking at X-rays.

We’re trying to find out what you’re thinking

This approach differs from that of sites like Zillow.com, whose goal is to attract an audience for its information and to sell advertising on the basis of the size of that audience.

Within a few months of its opening, however, Zillow attracted some unwelcome attention. In October, the National Community Reinvestment Coalition, a nonprofit consumer group in Washington, filed a complaint with the Federal Trade Commission that contended that inaccurate valuations on the site, both high and low, were damaging the interests of all consumers and particularly the interests of working families.

A ridiculous complaint, in my view, akin to suing McDonalds because you spill hot coffee on yourself.  Oh wait …

And it’ll make you jumpy too

 “We’re a starting point,” said the spokeswoman, Amanda Hoffman. “We’re not a crystal ball. It’s the Internet. You sort of have to take everything you read on the Internet with a grain of salt.”

Beyond the growth of home valuation sites, companies and individual real estate brokers are developing other methods to win customers with information online.

Back we come to the value of information; it lets you distinguish the specialist from the quack.

I’ve had a basic medical training

When Barbara G. Cox trains real estate brokers, she says, she encourages them to go beyond listings and use the Web to position themselves as specialists. For example, a specialist in horse properties can use a site to demonstrate knowledge about stabling, feeding and grooming.

“I’m telling them, in positioning, you have to distinguish yourself,” said Ms. Cox, co-author of “Internet Marketing in Real Estate” (Prentice Hall, 2000) and instructor of a course in real estate technology at Saddleback College in Mission Viejo, Calif.

Beyond factual information, there is also personal information — and markets, after all, are simply the sum total of all the information, including people’s opinions:

One man, one vote

As an extension of pure data about communities, Realtor.com is planning to add some consumer opinion, a feature that follows somewhat in the style of online retailers like Amazon.com.

For certain vendors, user-driven is terrific: it’s free, it’s direct, and it’s libel-proof, since the vendor isn’t saying it, another customer is. 

He conceded, of course, that public opinion could be tricky to manage in a high-stakes sales environment. He said that site administrators planned to allow residents to make recommendations — but that the site would employ editors to keep watch.

“It won’t be the wild, wild West,” he said.

Heading for the sunshine, living in the wild, wild west

No?  Just ask Wikipedia.

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