Editor's note: Following is the first 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 Lack of Analysis in the Public Domain

The discussions about the future of Fannie Mae ( FNM) and Freddie Mac ( FRE) are taking place in a vacuum, where there are no decent public analyses of the government's contingent liabilities with the two government sponsored enterprises. The main goal of this series will be to remedy that oversight.

I write this series in the face of genuine press and public surprise at the relatively good results of Freddie Mac. I do not mean to sound boastful, but I privately predicted those results quite accurately. This series will explain how I got to that prediction -- and where Fannie and Freddie losses go from here.*

Losses Are Not From Traditional Business

Fannie and Freddie traditionally insure qualifying mortgages. These are mortgages with:
  • loan-to-value ratios of less than 80% (or with supplementary mortgage insurance for higher loan-to-value ratios).
  • principal amounts owing lower than the qualifying mortgage limit (which used to be below $300,000 but has been increased several times during this crisis).
  • income, employment and assets verified.

These mortgages were never very risky and to date have caused very few problems (although Fannie and Freddie are provisioning for enormous problems that will come).

I can demonstrate this.

At the end of 2007, Freddie Mac had $26.7 billion in common stockholders' equity and 14.1 billion in preference shares outstanding -- a total of $41.1 billion in capital.

By the end of the first quarter all of that capital had been wiped out. In addition, Freddie Mac needed a capital injection of $51 billion from the government to maintain positive net worth. More than $91 billion in capital evaporated.

(Fannie Mae shares closed up 7 cents to $1.92, while Freddie Mac shares closed up 21 cents to $2.24.)

But the losses in Freddie Mac's traditional book of business to the end of the recent quarter were simply not that large. Here are the losses to the end of the second quarter -- with the $5.8 billion being the total realized losses (i.e., where they foreclosed and realized a loss) and $25.2 billion being the provisions for future losses.

Cumulative losses actually realized to date are simply not large enough to have caused problems. The $5.8 billion was well within the previous common shareholder equity. If that were all the losses, it would have been lower than the operating profit of Freddie, and the company never would have been loss-making. Regardless, it is nowhere near the $91 billion of capital that has evaporated.

Even provisions -- although large at $25.2 billion -- do not come close to explaining the total losses.

I point this out to observe something obvious but hardly commented upon in the public debate. The traditional role for Fannie and Freddie -- guaranteeing traditional qualifying mortgages -- did not (or at least has not to date) caused losses that are in any sense unmanageable for the system.

If this situation continues, it strongly supports the view that Fannie and Freddie can be bought back in their traditional role with relatively few risks to the public purse.

That is a big "if." There are plenty of people including some journalists I respect a great deal such as Peter Eavis who are convinced that these losses will wind up being enormous. Peter is, however, working in the same "model-free" environment everyone else is. In a later post I will model losses in the traditional business. In other words I will try to predict the future.

But the next post has a much more modest task -- which is to explain the past -- and hence inform as to where the huge losses that have already been realized have come from. Note that the next post does not discuss where future losses will come from. Instead, I just limit myself to the losses that have been booked already.

That should be easier -- it is almost always easier to explain the past than predict the future, but even then the conclusions will be controversial.

*I was not the only person to predict this. I have only once censored a comment on the Bronte Capital blog because it was too close to what I was thinking and stole my thunder. The last post in this series will reveal that comment and explain why I censored it.

Postscript: Peter Eavis has replied in the comments to this blog suggesting that I am misrepresenting him. He does not necessarily think the losses will be enormous, but he does think it unlikely that they will repay the government senior preferreds.
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.

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