Editor's note: Following is the third in a series of blog posts by John Hempton, the chief investment officer and founder of Bronte Capital. They originally appeared on Hempton's blog on the Bronte Capital Web site.

The previous columns were

Watching Fannie and Freddie, Part 2

, and

Watching Fannie and Freddie




) -- In my previous post, I showed you what had caused the big losses at

Fannie Mae


Freddie Mac

to date.

In short, it was mark-to-market securities (on private-label securities and the like) and interest rate-hedging instruments that collapsed in value as interest rates went to zero.

I also showed that these losses weren't likely to continue to be a drain on Fannie or Freddie.

What matters now is the vast, multitrillion-dollar books of traditional business that they guarantee -- mom-and-pop mortgages by people with good credit and no fancy mortgage terms or liars loans. These have not caused many actual losses to date -- less than $6 billion at each company -- but the provisions for losses from this business are large and getting larger.

It's the future losses we need to worry about. And so now -- unlike in the last post -- I need to make estimates about the future to see what losses

TST Recommends

will be

. Casey Stengel argued you should "never make predictions, especially about the future." At the risk of being exposed as a fool, I am going to breach Mr. Stengel's advice.

However, I have some tools for making these predictions. The purpose of this post is to introduce readers to these tools.

Both Fannie and Freddie publish default curves by vintage.

Default Curves That Point to the Sky

Here are the Freddie Mac and Fannie Mae curves from the last quarterly results.

These curves show the cumulative default of a pool of mortgages, as a percentage of the original pool balance, over time.

Note that Freddie Mac defaults are lower in all recent vintages than Fannie Mae. I had asked for explanations as to why that was and received the correct explanation (I've since checked it). Almost the entire difference is that Fannie Mae did considerably more business with




, and hence has a worse book of business in aggregate.

Also note that the curves for 2006 and 2007 in particular are very sour at both companies, while 2005 was a bad year, but probably manageable, and 2004 and prior years will cause few problems.

Default, Not Loss Curves

These are default curves, not loss curves. To turn them into loss curves you would need to know the severity by vintage, and neither Fannie nor Freddie publish enough information to work that out (though you can get some reasonable estimates from the published data).

Take again the Freddie data. The 2000 vintage pool, meaning all the mortgages guaranteed by Freddie Mac in 2000, has had a cumulative default of about 1.07%. That means that 1.07% of the mortgages written in that year defaulted. Prior to the current mortgage bust, 2000 was considered a bad year of business.

Nonetheless, a 1.07% default didn't cause any problems for Freddie because the severity (loss given default) was less than 10%. The 1.1% default caused about 10 basis points of loss over a decade. Given the guarantee fees were almost 20 basis points a year, this pool of business was profitable.

The problem with the 2006 and 2007 vintages is that not only is the cumulative default quite large, but the severity also will be very high. Fannie Mae severity during the last quarter was more than 45%. High defaults multiplied by high losses given defaults means big problems.

How big, and how you might model them is the subject of the next post.

-- Written by John Hempton in Bondi Junction, Australia


John Hempton is chief investment officer and founder of Bronte Capital, an Australian based global asset management firm. He was formerly a partner at Platinum Asset Management and has served as chief analyst of tax policy for the New Zealand Treasury.