Article: Gov't. "Watchdog" Bamboozles Press About Fannie and Freddie

All along, the GSEs maintained their own systems of risk classification for loans in various stages of delinquency. And, consistent with accounting standards, they booked credit losses as soon as they saw signs of trouble. Over the past seven years, the GSEs methods for booking credit losses have proved to be excessively conservative, because actual proceeds from foreclosure liquidations were higher than the GSEs estimates of recovery.

In April 2012, the FHFA announced that the GSEs should change over to the risk classification systems used by bank regulators. Every banker knows those risk categories, which also represent successive stages of deterioration: Pass, Special Mention, Substandard, Doubtful, and Loss.

Generally speaking, a bank assigns a loss provision to any loan that has deteriorated to the Substandard category. The loss provision may increase as the loan deteriorates to Doubtful. When a loan is classified as Loss, the loan is written down, so, as in the GSE example above, the $100 loan and the $20 loss reserve will be converted into an $80 loan with no reserve. But the actual losses hit the income statement much earlier.

In terms of substance, what is the difference between the GSEs and the banks? The GSEs write down their loans as soon as the loan servicer initiates foreclosure proceedings, whereas, under bank regulations, the loan must be written down once it becomes 180 days delinquent. But again, writing down the loan should not impact the income statement. It's a timing difference that should wash out over time.

- It insinuates that the GSEs were not maintaing proper risk classifications for their loans.

- It insinuates that the date when a loan is written down is the same as the date when the credit loss is recognized on the income statement.

- It insinuates that the GSEs failure to follow bank regulators' terminology, which designates retail mortgage loans in the "Loss" category once a loan is 180 days delinquent, is the same thing as failing the recognize a loan loss provision on the income statement.

- It insinuates that the GSEs are not fully compliant with Generally Accepted Accounting Principles, which debunked by the unqualified opinions from Fannie and Freddie's auditors, Deloitte & Touche and PricewaterhouseCoopers.

And the usual suspects embellish false insinuations to amplify the media narrative

As you would expect, the usual GSE haters took the media narrative and ran with it. As with Steve Linick's dubious report, all of the big accusations against Fannie and Freddie follow one singular template; they rely on word games to fabricate some kind of false equivalency, and they ignore empirical data that nullifies the accusation.

Take, for instance, Ed Pinto's claim that the GSEs caused the mortgage crisis because of all their subprime lending. He contrived a false equivalency between Pinto-designated "subprime" mortgages and "subprime" mortgages as designated by everyone else, and, since 2008, he refuses to ever discuss empirical loan performance in the context of the GSEs versus the rest of the market.

Pinto disciple Chris Whalen follows that template with,

"Are Fannie Mae and Freddie Mac Really Profitable? Really?"

Whalen is a bank analyst, so, unlike the man on the street, he should know the difference between a loss provision and a write-down, and the difference between recognizing a loss for accounting purposes and a regulatory classification of "Loss." And he knows how to read Fannie and Freddie's public filings, which disclose the information that he chooses to bypass.

Let's start with what he overlooks. From here on in, we will get into the weeds of accounting and financial analysis:

First we start with Page 96 in the notes to the consolidated financial statements. As of June 30, 2013, FNM had about $140 billion in total delinquent loans on its balance sheet, including about $80 billion in the "seriously delinquent" category. Good guess for loss given default on this subset of bad paper is well north of the high 20% rates that FNM is reporting on current disposals and the 40% loss severity rates we hear discussed in polite society. One particular RMBS veteran thinks the severity on the 04-08 vintage is more like 60-70% because so much of the underlying collateral remains under water. The remaining delinquent loans total about $60 billion. FNM has about $50 billion in reserves set aside to cover losses on these bad loans and other assets.

OK then, as of June 30, Fannie had a $2.8 trillion single-family mortgage book, $140 billion in delinquent loans, and a $50 billion loss reserve, which assumes a loss severity of about 35%, which, Whalen insinuates, is far too low.

Copyrighted Image? DMCA

by D.Fiderer
v> First of all, this has nothing, zero, to do with the FHFA IG report. But we don't need to guess what Fannie's loss severity has been for the past 5-1/2 years, we can read Fannie's 10-Ks , which show that loss severity peaked in 2009, at 37%, and fell to 31% in 2012. Given that the most distressed real estate markets have seen double-digit price increases over the past year, reduced loss severity makes sense. And given current and historical levels of loss severity, Fannie's 35% loss-rate assumption look reasonable.

"One particular RMBS veteran thinks the severity on the 04-08 vintage is more like 60-70%," is a false equivalency right out of the Pinto playbook. The latest TCW Mortgage Market Monitor shows, on page 43, that defaulting Prime loans held by private label RMBS had a loss severity of 41%, Alt-A loans had 55% loss severity, and for subprime loans it was 72.5%. Whalen wants to insinuate that Fannie's loans are just like private label securitized subprime loans, which is the idea that made Ed Pinto famous.

And from that flimsy pretext, Whalen insinuates that Fannie is concealing $50 billion in losses. He also says that tens of billions in losses would emerge if Fannie adhered to the FHFA guidance, which is flat out false.

So if FNM was to immediately implement the new accounting rules put in place in 2012, the question is what losses would be applied to the $140 billion? Looking at the loss severities for FNM loans bandied about by analysts, a haircut of about 40% would seem like a good point of departure. But let's instead go back to the figures as the top of this piece. If we put a 60-70% loss severity on that $80 billion in seriously delinquent loans, we are talking ~ $50 billion right there. Take half that rate -- 30-35% loss given default -- on the remaining delinquent loans and we get another ~ $20 billion or $70 billion or so in total charge offs against reserves.
Why the divergence from current FNM loss severities in the estimates? Because, as is axiomatic, the better loans and REO assets with lower losses tend to get sold first. To be conservative, in keeping with the FHFA guidance, a more severe haircut is appropriate. If the loss severities turn out to be lower, then the enterprise can book a recovery to loss reserves, which will positively affect income.

So if we were to implement the guidance from FHFA today, it is pretty clear that the profits of the GSEs would have been largely offset by the allocations needed to replenish the reserves. If we use the income figures from the FNM 10-Q, all of the "profits" from 2012 and the first half of 2013 would disappear, and then some. Reserves of $54 billion would be consumed and another $10-20 billion would need to be immediately allocated from income to cover the balance. Treasury would need to replace this deficit to avoid seeing FNM operating insolvent. Just for giggles, compare this adjustment to the $1.6 billion in charge-offs taken by FNM in Q2 2013 under the current rules.

FNM would then need to retain income to replenish reserves for future losses, but fortunately loss rates on new production are far lower than during the awful 2004-2008 period. Arguably a reserve buffer of $25-30 billion or half of current reserves would be a reasonable starting point for the "new," post crisis FNM. Some may differ with my view on loss severities, but for an investor in FNM, a $60-70 billion unrealized loan loss certainly seems material to me.

Whalen frames his analysis on the premise that Fannie is lying, because it has always lied:

After years, no, really decades of obfuscation and outright mendacity, are the folks at Fannie Mae and Freddie Mac really telling us the truth now about their financial condition? Washington is a city of lies, let us remember, with a good part of the population paid to disseminate falsities as part of their job description. But the biggest lie of all was allowing the GSEs to avoid marking their impaired assets down to fair value as commercial banks are required to do. Had this been done, the losses reported by the enterprises would have been far larger.

Speaking of which, we are still waiting to see how Whalen's other prediction, about Fannie and Freddie concealing $100 billion in losses, plays out.

As for the years of obfuscation and mendacity, check out:

Fannie Mae "Accounting Scandal" Discredited In Court

SEC Reversed Its Initial Charges Re: Fannie Mae's "Accounting Fraud"

(Note: You can view every article as one long page if you sign up as an Advocate Member, or higher).

Homeownership And Conservative Myths About Affordable Housing Policy (Article) ((View How Many People Read This))	11/01/2015
Fannie, Freddie and the Right Wing Myth of a "Mortgage Meltdown" (Article) ((View How Many People Read This))	02/07/2015
Koch Bros./GOP Brain Trust For Housing Finance "Reform" (Article) ((View How Many People Read This))	04/18/2014
View All 18 Articles in "Fannie Mae & Freddie Mac"