FHFA's DeMarco Speaks - Ouch!

Bruce Krasting's picture

FHFA’s Acting Director Edward DeMarco provided written testimony
to the Senate today. I would give his presentation a B+. There is
little room for optimism in this story. Mr. DeMarco did not gloss that
fact over. A few snips from that speech:

July 2007 through the first half of 2009—combined losses at Fannie Mae
and Freddie Mac totaled $165 billion. In the first half of 2009, Fannie
Mae and Freddie Mac together reported net losses of $47 billion.

the establishment of the conservatorships, the combined losses at the
two Enterprises depleted all their capital and required them to draw
$96 billion. The combined support from the federal government exceeds $1 trillion.

short-term outlook for the Enterprises remains troubled and likely will
require additional draws under the Senior Preferred Stock Purchase

That’s funny; I thought things were going so well. From the WSJ 8/8/2009:

Some random comments on credit conditions:

-Among subprime adjustable-rate mortgages, nearly 40 percent are seriously delinquent.

really ought to string someone up over this number. A 40% default rate
is not bad judgment. It is a crime. It is what kicked us over the top.

remain concerned and recognize the risk associated with increasing
numbers of seriously delinquent loans and higher forecasted
foreclosures. In particular, we are concerned with the continued
increase in serious delinquency rates, even among prime mortgages.

Read this to mean, “The next shoe to drop will be prime mortgages.” It was always perceived that prime mortgages were money good. They are not.

On the issue of REO (real estate owned from repo/default)

Currently the Enterprises are managing a real estate owned (REO)
inventory of almost 100,000 properties, a number expected to grow.

government can’t sell this crap. If they did, it would just tank the RE
market and cause more Prime defaults. Uncle Sam is going into the
rental business big time. But that does not look too promising either.
Some sobering thoughts on that market:

of mid- year 2009, rental vacancy rates hit their highest level since
the U.S. Census Bureau began tracking vacancy rates in the 1950s.

That does not sound like a plus for CRE either.

There are obvious problems at the FHLB’s. Do these words trouble you?

most important financial development among the FHLBanks in 2009 is the
deterioration of the PLS portfolios held by the FHLBanks.

big a problem is this? Big. I smell bailout. The question that must be
asked and answered is, “Why were the FHLBs buying private label
mortgages? What were the rules on that? Someone made out big on the
sale of those securities.

retained earnings were $6 billion, but negative accumulated other
comprehensive income (AOCI) exceeded retained earnings at the six
FHLBanks with the greatest PLS exposure.

A good number
of people were paid a fair amount of money to come up with the term
AOCI. What would be a better description of "Negative Accumulated Other
Comprehensive Income"? The word "loss"comes to mind.

You have to give DeMarco some credit for the following. The accountants may be lying but he is not:

decline in the carrying value reflects impairment charges of almost
$8.2 billion, however, a change in accounting rules resulted in only
$953 million charged against income.

On the issue of interest rate risk management at Fannie and Freddie DeMarco gives a ‘tell’.

-The Enterprises’ investments in mortgage assets expose them to market risk. Given the uncertainties in the marketplace, managing market risk continues to be a challenge.

There was a spike in interest rates earlier this year. At that time someone did very big amounts of ‘duration’ trades. I believed then
that it was the Agencies puking it out at the bottom of the market. I
think Demarco confirmed it. Look for big derivative losses in the third
and fourth Q’s for both F/F.

On the complicated issue of mortgage insurance (PMI) comes this from DeMarco:

-The Enterprises will refinance those mortgages (ones in default) without requiring additional private mortgage insurance. If there already is mortgage insurance on the existing mortgage, that coverage will carry forward to the new mortgage.

is a flat out subsidy for the PMI providers. When a loan goes into
default and a loss is realized the insurance that is there should cover
a significant portion of the loss. By rolling the loans the loss is
avoided, and so is the necessity to pay up on the claim. This is
keeping the PMI folks alive and well. One of the larger players in this
space is AIG. We wouldn’t want to do anything that would hurt them
would we?

The following warmed my heart. Finally someone is owing up to how we got into this mess:

-The markets relied upon an implicit government guarantee of Enterprise securities.

created and sold the lie that the US Government was behind $5.3
trillion in dodgy MBS paper? It was a few dozen politicians, folks at
Treasury, the entire mortgage industry, most of Wall Street and
everyone at Fannie and Freddie.

Finally, a confirmation from
DeMarco that there is a plan coming. Of interest is that the timetable
seems to have been accelerated. This was supposed to be a March 2010
issue. The Director suggests it may be here in time for Santa. I can’t

-I know the Administration has committed to addressing (the GSE’s) in the coming months.

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Anonymous's picture

Thanks for the no-nonsense commentary.

Explanation of TLAs and ETLAs (three-letter acronyms and extended three-letter acronyms) for ignoramuses like me would be appreciated. Thanks.

bonddude's picture

CW-the MAN. Nice job on CNBC recently.

whalenc's picture
whalenc (not verified) Oct 9, 2009 4:23 PM

Extend and pretend is the operative strategy for financials. Note that the default and REO rates for the GSEs are same levels as banks.  Was not supposed to be that way.

Anonymous's picture

Is that really you Chris?

Anonymous's picture

Extend and pretend is the operative strategy for now. W/O a huge bounce in the economy, however, the warts start to show and ooze in 2010 in all financials.

DaddyWarbucks's picture

Thanks Bruce. It seemed like the PMI providers would have been completely vaporized in this enviroment but it looks like they are on the teat too.

jbc77's picture

Great article. I love zerohedge, this is the place you come to find information they won't and can't talk about on television. Hats off to Bruce.

Ned Zeppelin's picture

Fantastic post, Bruce. Thank you.

Anonymous's picture

does anyone wonder what the endgame of all this is?

here's some tinfoil questions:

who owns much of the agency debt now?
who's collecting interest off that debt?
what happens if/when those agencies start to default?
what if there is a debt-for-equity swap?
what is the liquidation value of the equity?
aren't the assets mortgages?
what are those mortgages backed by in case of default?
what is the % of mortgages owned by the agencies?

we don't think the FED is making out badly at all. even in the worst case scenario, they could be the largest landowner in the USA.

not bad if you can hold it for 20-30 years.
how's that for 21st century feudalism?

Anonymous's picture

Excellent work Bruce. If you haven't posted this on SeekingAlpha, I would ask that you do so. This is unbelieveably vital to understanding just how hosed the average taxpayer is becoming thanks to a microwaving of the books that has turned this frozen turkey into a briquette.

ghostfaceinvestah's picture

BTW, not sure if you say this a few weeks ago.  Not a bad editorial, several things I agree with.


"If the government decides to do more to support those borrowers, it can do it more directly through the FHA and the Government National Mortgage Assn. (better known as Ginnie Mae)."

Agreed, as I have been saying, why three agencies, one is enough.

"The Fed can increase the availability of credit by using its emergency authority to buy mortgage-related securities. And in Europe, a type of security called covered bonds has enabled banks to raise the capital for mortgages without the help of government agencies. Covered bonds also penalize banks more tangibly for the bad mortgages they sell to investors, giving them an incentive to issue loans that are likely to be repaid. Fannie and Freddie helped eliminate that incentive in the United States, to the detriment of borrowers and taxpayers alike. It's a mistake we can't afford to repeat."



ghostfaceinvestah's picture

A few comments:

First off, another excellent article.  It is articles like this that keep me coming back to this site; far better than any other website, MSM or blog.

"A 40% default rate is not bad judgment. It is a crime."

It is immoral, is what it is.  Look at the GSEs own books - over 10% of their "credit enhanced" (read-high LTV) credit book is seriously delinquent (90+).  But what is the government doing?  Still encouraging low-down-payment mortgages.  When you extend credit to a cohort where more than 1 in 10 will default and lose their house, that is immoral.

"This is a flat out subsidy for the PMI providers."

The relationship between the GSEs and the MIs is pretty complicated.  I wouldn't be so sure this is a subsidy for them.

The GSEs are keeping them alive far beyond what they should, because the GSEs have not developed a viable option for credit enhancement (there is in fact an option that would be better for everyone, that is forcing the banks to keep a 10% participation on every over-80 loan, but the banks want nothing to do with mortage risk, they are all too happy to originate and sell, like they have always been doing).

So, in order to compete with the FHA, they need to string along the MIs.  The GSEs, by the way, hate the FHA, from what I have gathered from my dealings with them.  Probably because they rightfully fear being rolled into the FHA.

If given an opportunity, the GSEs would love to be able to self-insure.  However, they would take a change in their charter, which is not going to happen in this environment.  Once that gets opened up, the whole thing gets changed, not just the credit enhancement options.

So they are stuck with using the MIs, at least for now.  But Fannie made an interesting move the other day - they announced that they will now accept minimum level MI coverage.  What is that?  According to their charters, the GSEs only need coverage down to 80LTV, but have traditionally bought coverage down to 65LTV (why I am not sure).  but fannie announced they will give lenders the option of only buying down to 80 coverage, in exchange for a higher gfee.

Fannie of course positioned this as "helping the MI industry".  Some help, taking 50% of their business.  If you are an MI, your future business prospects just got slashed in half.  Nice.

As for the refi thing, the whole issue was complicated.  The government wanted the GSEs to be able to refi underwater borrowers, but according to their charter, again they needed MI coverage.  So a 75LTV that is now 100LTV would need to buy MI.  That would reduce the benefit of a refi.  That is when Lockhart got the lawyers to claim this was not really a new loan purchase, but a modification (funny that, since a new note is created, how is that not a new loan purchase).

To keep the charade going, they had to also claim the LTV hadn't changed on the MI-insured loans, thus no change in coverage.

The MIs themselves can't insure over 105LTV in most states, so they need the charade to hold up as well.

So the relationship between the GSEs and the MIs is not as clear cut as it seems.  Not to mention the MBA panel who basically threw the GSEs under the bus had two MI representatives.  I doubt the GSEs were thrilled about that nice plan, to shut them down and put them into runoff.

As for the AIG sub, rumor is it is going to be sold soon - there was a story a few weeks ago about Wilbur Ross buying it.  Who knows, all I know is they got rid of their long-time CEO a few months ago, installed some lackey of that woman from Safeco (who is now gone), and laid off a ton of their staff.  They are pretty much done.

McGriffen's picture


excellent comments.  gotta be a mortgage wizard dropping the kind of hard facts herein

Anonymous's picture

This stuff is too complex for the average American. It needs to be translated into an iPhone app before people get interested.

Anonymous's picture

Huffington Post seems to be picking up more on the economics of our Titanic but I doubt they will post anything that will reflect too badly on our current leadership. American leadership of course being a phrase that should be bracketed with the Spanish style question mark fore and aft.

Drudge, that's an innumerate readership over there so you will have to use simple words and tie it into Ted Kennedy driving over the bridge and taking Rosemary's Baby down with him. As a matter of fact, just skip the economics entirely and write a post on him performing abortions will deny Republican voters their crop price supports and will put a terrorist in the trunk of every GSE GM car.

deadhead's picture

Huffington Post seems to be picking up more on the economics of our Titanic but I doubt they will post anything that will reflect too badly on our current leadership

HuffPo consistently and prominently publishes pieces that are brutal on geithner, summers and the Fed.  though it is clearly a pro Obama site,  they are not at all pleased with his handling of the wall street, banking mess.  or should I say, they are not pleased with how wall street is handling Obama

Miles Kendig's picture

True enough.  The fact remains that the lessons learned at the SF FHLB during the "resolution" of Silverado that gave cover to the illusion that the FHLB system had never suffered a loss of public funds have been carried forward on a systemic basis. This particular topic is a wretched hive of scum and villainy that remains ripe for manipulation for fun, profit & the attempt to maintain the illusion of proactive policy formulation at the expense of assuming tremendous risks on behalf of folks who, for the most part have little understanding of what exactly is at stake or how these actions are all interconnected.

Regardless, I join you in welcoming Bruce's work on these subjects as he consistently demonstrates in practice what the terms research & analysis should be.  Too bad other forums ignore this ongoing maturation process and what is being produced from it.

Green Sharts's picture

There should be an investigation into why the PLS portfolio of the FHLB has deteriorated so badly in 2009 and who the securities were purchased from.  They must have bought a lot of subprime because a lot of private label Alt-A and prime PLS have generated very good total returns this year.


ghostfaceinvestah's picture

I'd bet he is talking about the actual performance of the PLS portfolios, and not the market prices.  See my post below - I seem to remember the FHLBs getting an accounting break on the private label bonds, cause mark-to-market would have put 8 of the 12 in breach of capital limits.  So they changed the accounting rules.

But in terms of actual losses, the performance of the underlying collateral has been deteriorating across the board in 2009 - Alt A, Prime Jumbo, HELOCs, you name it.  Subprime is one of the few that hasn't gotten a lot worse in 2009, cause it was so bad going into 2009.

The secondary prices of some bonds have started to improve due to liquidity (to the point where I think many are overpriced based on underlying collateral performance), but the projected losses have had to increased.  Very few people expected the collateral to perform as badly as it has (permanent skeptics like myself excluded).

Bruce Krasting's picture

Bingo! Last year this stuff was worth 40 cents. Today it is 60. That looks like a 50% gain. But the FHLB's never wrote it down to 40. They probably have this it 80. So there are still losses to come. There is no 'mark to market' at the GSE's. I am not clear on the magnitude of this problem. They have showed a number of 170b of 'other' stuff.

Make a guess. It is worth 70c from where they are today. From there you could again guess that the range of losses in 20-60 billion. I think anything in that range deserves a closer look by someone. But the question is who? I know, It would be the FHFA. The guys looking after our interests....

Green Sharts's picture

Last year this stuff was worth 40 cents. Today it is 60. That looks like a 50% gain.

Plus they would have collected the coupon of probably 6-8% on par, which is 15-20% on 40.  Also, the principal being repaid each month comes back at par and in large pools there would be some prepayments at par due to refinancing or a resale.  Total return in that type of scenario could have been 60-80%.

But the FHLB's never wrote it down to 40. They probably have this it 80.

I don't get it.  The comment from the FHA official in the article was that there was significant deterioration in the PLS portfolio in 2009.  Surely they didn't maintain existing marks in 2008 as the market was crashing and then start marking down in 2009 as the market was rebounding?

McGriffen's picture

Coupons very, very likely indexed to 1m LIBOR.  And, to the extent cashflows are not being chewed up by losses eating through capital structure, the total return scenario suggested is too "cheery".  CPR rates had been ~ 3-5 (voluntary prepays) on a typical 2006-2007 deal.

If those bonds are indeed subprime, and were issued as 3-yr sequential pay it's also possible the principal is not being amortized.  I could ramble more but won't, it's pretty useless to resist.

bonddude's picture

It is likely, particularly on whole loan backed paper, that these "agencies" bought the worst bonds or mbs. Likely that the structures take the coupons to ZERO extending average life and crashing the pricing to very low levels. Don't forget about the cdos and cdss written against this garbage.

What a mess.

ghostfaceinvestah's picture

Didn't they get some special treatment to get around their solvency problems?  I seem to remember something, but the only story I could find was this.  Maybe it was as simple as being able to classify some losses as temporary, and only count the "other than temporary" against capital?  Whatever, the regulators gave them some break, I seem to remember.


"The Seattle FHLB, a cooperative that lends money to its member banks at below-market rates, has accumulated $247 million in net losses over the past four quarters, mainly because of losses in its pile of mortgage-backed securities.

The bank's $16.2 million first-quarter loss would have been even deeper if not for a timely change in accounting rules."

Anonymous's picture

[" Other Comprehensive Income"? The word "loss" comes to mind.]

What loss? If they pay a billion and a billion in "nonaccumlated" (aka "realized income") has been returned but $2 billion is still owed but is now unrecoverable, how much was lost?

Many from the business world have great difficulty with the zero-sum game of secular accounting where profit is failure.

The term "Negative Accumulated" is the very definition of an Oxymoron, and just like in banking, what you think would be a debt is often considered an asset and "VICE"-versa.

spekulatn's picture

 Very well done sir.


Agreed, this piece needs to be Drudged.




gookempucky's picture

Second that DH

Maybe this will clarify the Theater of the absurd.

Thanks Bruce

deadhead's picture

Bruce...thank you very much for parsing this out.  Well done and appreciated.

Why don't you submit this to HuffPo, Drudge?  Their readership should be aware of this.



Bruce Krasting's picture

I send them stuff. They don't care. Thanks.bk

john bougerel's picture

Thanks Bruce,


nice to know an honest guy is acting director at the FHFA and appreciate the heads up on the timetable for an FHFA "plan" or "whatever?"