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Watching Fannie and Freddie, Part 5

Revenue at these government-sponsored enterprises has risen very sharply.

Editor's note: Following is the fifth 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.

Here is the first part;


second part

; the

third part

; and the

fourth part.

In parts one to four of this sequence I explained where the losses already realized at

Fannie Mae


Freddie Mac

came from, and where future losses might come from. I showed that the companies almost have reached reserve adequacy -- a conclusion diametrically opposed to the consensus view that these companies are hopelessly insolvent even to the point that they threaten U.S. government solvency. On losses, the consensus appears to be simply wrong.

In this post, I show how the revenue of the government-sponsored enterprises is up very sharply.

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As far as Fannie and Freddie are concerned, the best thing about the mortgage crisis is that these institutions are now the whole market; the private sector market in U.S. mortgages almost has entirely disappeared. The companies are even allowed now to do jumbo mortgages.

Lack of competition means fat margins. Just as the revenue of

Bank of America

(BAC) - Get Report

rose sharply during the crisis, so did the revenue at the GSEs.

Here is the quarterly sequence of net interest income for Freddie Mac. The numbers for Fannie are similar.

The growth in these numbers is breathtaking. Operating costs are roughly flat. You would think they'd be rising because of foreclosure and credit management, which costs Freddie money. However, I suspect these costs are offset by lower bonus payments to staff and similar costs.

But with flat costs and revenue rising like this, Fannie and Freddie are much more profitable on a pretax, pre-provision basis.

Not all of this growth in profit is sustainable. A bit is reversal of previously booked losses on derivative hedging instruments. (I explained this reversal in Part 2 and the explanation is technical. I don't feel the need to repeat the explanation here.)

They Just Don't Get Fannie and Freddie!

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Further, Freddie Mac, in particular, has been an astoundingly good judge of when to hedge out duration risk. I have written in the past about just how good Freddie's trading has been. The seemingly superior, interest rate risk management at Freddie has continued, though I wouldn't bank on profits from that being permanent.

That said, the pretax, pre-provision profits at Freddie are probably going to run about $15 billion a year for a while. Much of that increase will be long-lasting as private sector competition in the mortgage market is not going to return rapidly, and so margins should remain fat. That $15 billion a year can offset an awful lot of losses.

What it means for the future of Freddie and Fannie 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.