Editor's note: Following is the seventh 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; the second part; the third part; the fourth part; the fifth part and the sixth part.

WASHINGTON ( TheStreet) -- In Part 6 of this series I came to the (nonconsensus) conclusion that both Fannie Mae ( FNM) and Freddie Mac ( FRE) were long-term solvent and that the cost to the government of their conservatorship would be zero. I also suggested that the common stock had value and that the (noncumulative) preferred shares (currently trading at 4 cents to 6 cents on the dollar) would one day receive par.

There are model sensitivities and economic sensitivities to this conclusion. In this post I want to (begin to) explore how robust this conclusion is, starting with the model in Part 4. I am conducting an "idiot check". In the next two posts I will do idiot checks on Part 5 and Part 6.

I apologize in advance as these three posts will look a little disjointed compared with Part 1 and Part 6. In this post I am using all sorts of anecdotal or practical data to test my hypotheses. This is a practical, not theoretical, exercise, and as a result it is messy.

Background

In Part 4 I built a model that predicted future credit losses for Freddie (and told you I had done the same for Fannie). We know that huge credit losses are coming at Fannie and Freddie because delinquency is rising, house prices are awful and default is becoming more commonplace. My model allows for huge losses. The main question is whether the losses allowed for are huge enough. The bears (and there are many) seem to assert losses considerably larger than I am projecting.

Well let's start with one of my favorite charts of the traditional mortgage guarantee business. Again I do this only for Freddie, leaving the reader to do it for Fannie if he or she wishes.

Reserve for Loan Losses

In this graph we have $1.907 billion in charge-offs during the last quarter and $1.104 billion in the quarter before. The charge-offs were affected by the foreclosure moratorium, which would have meant charge-offs were understated in the first quarter and overstated in the second quarter. Let's call it an average of $1.5 billion per quarter.

At the end of the second quarter there were $25.2 billion in reserves. I calculated in Part 4 that an additional $12.5 billion would need to be provided for over the out years. We have thus built $35.7 billion of loss reserves (current reserves and reserves to be taken) into our model. The key sensitivity question is: Is this enough?

Well, if the loss rate does not get any worse, then $35.7 billion at $1.5 billion per quarter would last 23.8 quarters, or almost 6 years. I can be fairly confident that if realized loss rates do not rise then model reserves are adequate -- as the alternative requires substantial numbers of people who obtained their mortgage in 2006 to remain current until 2014 and then default. That is possible if the economy is really sour in 2014, but it is not an obvious or expected outcome.

More realistically, I am modeling realized losses rising for some time before falling. Foreclosure stats are rising in aggregate, although they're rising at a slower rate. If realized losses doubled we could last three years and still be reserve-adequate. That is roughly what the model would imply. If realized losses triple and remain at that rate then (unfortunately) my $35.7 billion in losses still to come will wind up being an underestimate. So, in a sense, what is required is some comfort that the realized loss rates, particularly in the nasty 2006 and 2007 vintages, are unlikely to do much more than double from here.

Test 1: What's Happening in California

California is the worst state for losses for both Fannie Mae and Freddie Mac. Some states (particularly Arizona and Nevada) have higher losses as a percentage of loans outstanding. Some states (particularly Michigan) have higher severity, with many houses recovering less than $2,000 on foreclosure. But California is a massive state with high house prices and high losses. Arizona and Nevada are simply not large enough to make my estimates wrong. California is.

Fortunately, California has very good data on defaults, notices of trustee sales and recoveries at trustee auctions, courtesy of Foreclosure Radar. Paul Kedrosky, who writes TheStreet.com's "Weekend Reading" column, has pointed out that we have reached the "new normal" in California -- a stabilization of foreclosure processes at high levels.

California Foreclosure Activity

The point is that the worst state has stabilized. This tends to indicate that the defaults are not even going to double from here, let alone triple. On this piece of evidence my default loss estimates are overstated and Fannie and Freddie will return to full solvency more rapidly than I previously anticipated. Moreover -- adding to the robustness -- the proportion of realized losses happening in the "bubble states" (California, Nevada, Arizona and Florida) has been rising by quarter, not falling, so it is reasonable to assume that as go the bubble states, so goes the whole book.

Test 2: Early-Stage Delinquencies

Early-stage delinquency (particularly 30- to 60-day buckets) is the best leading indicator in delinquency data. 90-day-plus delinquent loans will continue to rise well after the economy or credit cycle has turned because bad loans accumulate, especially when selling foreclosed property is hard. By contrast, loans going through the 30- to 60-day bucket give you an idea of the flow rate into problem loans. When the 30- to 60-day delinquency improves you know the credit problems are ameliorating (even though the 90-day buckets are getting worse).

One of those hopeful leading indicators is that in many categories of loan I look at, the 30- to 60-day buckets are improving -- and usually improving more than seasonal factors indicate. (That bucket is seasonally difficult in February when the Christmas bills come due and easier in summer because there is more overtime or temporary work about. Incidentally, 30- to 60-day buckets are getting better in some credit card books as well.)

Fannie and Freddie (unfortunately) do not give early-stage delinquency data (I believe because the loan servicers report the data inconsistently). However, the Office of Thrift Supervision has recently conducted a survey. You will find the following chart, and much more data like it, on the OTS Web site.

Mortgages 30-59 days

Again, this indicates that is unlikely the charge offs will even double. It is unlikely to more-than-double, and again it seems my loss estimate is too high.

Estimate Defaults vs. Amount in Mortgage Pool

The model presented in Part 4 estimated losses for each year of business. Here is the table again:

Year-by-Year Estimated Losses

Now we estimate that (as of year-end 2008) there were $13.2 billion of losses (and $21.9 billion in defaults) left to come in the 2006 year of business.

The Freddie Mac credit supplement gives us other data about the credit in that year of business.

Single-Family Credit Profile by Book Year and Product Feature

In the 2006 vintage there is only $236 billion of unpaid principal balance left -- and that number is falling quite fast. (The rest has been refinanced, has defaulted already or has been repaid.) We have built into our model a 9.28% default rate from here. Given that the seriously delinquent loans are only 6.34%, that seems a little harsh: All seriously delinquent loans need to default and then there needs to be another serious round of new delinquencies. Given that most delinquencies cure (even in times like this) because people with a default notification often try hard to pay rather than have their house foreclosed on, it does appear to be a high estimate to have required foreclosures at about 1.5 times the current delinquency.

I guess -- and people will say this -- that people could walk away, with loans going from current to default very rapidly. Thirty-four percent of the loans have a current loan-to-value ratio of more than 100%, and almost all of those loans are current. My only counterargument -- and I know this is a weakness -- is that while it may be in their interest to walk away from their mortgages, they are not doing so.

It could be that they are unaware that their loans are underwater (and there is some evidence that Americans know home prices have fallen but delude themselves about the value of their own homes). It could be that they just have good credit, the loan is not significantly underwater and they want to pay. It could be that they have scattered Daddy's ashes in the backyard and walking away is unthinkable. What's more likely: With a 90% LTV loan on a $200,000 house you might not walk away even though the mortgage is underwater because the mortgage payments are lower than the cost of renting an equivalent home.

Regardless of the reason, they are not currently defaulting. That is all I can say about this data. If people have data that suggests that this will change soon, I am interested. I see no data in aggregate proving that point, although there have been some data about the extent to which people are deluded as to the value of their own homes and that their level of delusion is correlated to economic conditions.

The Shift in Housing Problems

The housing market crash began with low-end housing. In most markets jumbo mortgages retained fairly good credit until recently, although there is considerable evidence that upmarket housing is experiencing trouble now. There is also considerable evidence, much of it anecdotal -- that lower-end housing prices have stabilized. (Certainly in most markets it is considerably cheaper to buy low-end housing and make mortgage payments than it is to rent.) This is generally supportive of my thesis as the critical 2006 and 2007 books at Fannie and Freddie contain no mortgages of more than $330,000.

An Observation About Second Derivatives

As indicated in Part 6 we at Bronte purchased Fannie and Freddie preferred stock fairly aggressively for less than 2 cents on the dollar. It was March when we first started doing that, and the world looked like a sour place. The idea that Fannie and Freddie might actually be solvent seemed unthinkable, but we were busy thinking it.

At the time, everything was getting worse at an increasing rate. The expression is "free fall," where you simply accelerate towards some immovable hard object.

The modeling did not feel very robust, and the reason it did not feel robust was that all the leading indicators were getting worse. In the curves in Part 4, the 2006 and the 2007 curves were accelerating away from 2000 curve. They did not look bounded at any multiple of the 2000 curve that I could get comfortable with. I knew defaults would continue to get worse for a while because there was a big buildup in the delinquency buckets and delinquency is a precursor to default.

What would have made me confident (and believe me I was not confident) was a deceleration in the rate at which things were getting worse. I was interested in the "second derivative." For a while (until about April) the second derivatives all looked good. Briefly, the second derivative of total delinquency looked bad (as reported in Fannie's monthly data), and that really rattled me. I posted that here. As it turns out, that data point was an exception to the general trend. Only recently there have been a few bad data points (for instance, the recently reported rise in early-stage delinquencies at Capital One Financial ( COF) suggesting a W-shaped recovery).

With anything that looks like a W-shaped recovery this model could be wrong. For instance, we could have another big leg down in either property prices or the economy. The data generally do not support that second leg down, but that might change. The Capital One numbers have given me pause.

But more generally we are making predictions that are ultimately just guesses. I hope I have convinced you that they are educated and rational guesses. But they are guesses nonetheless.

The main objection I have received so far is about loans with risk-layered terms that Fannie and Freddie have in their traditional books.

There have been a few objections (mostly in email) that suggest that I assume away much of the dross in the conventional Fannie and Freddie books. Here is one email, from "bob", a mortgage market professional:

Well reasoned, but... there is a presumption in the marketplace that Fannie & Freddie's book of traditional business is solid stuff (emphasis added). One has to really question that. What about the 100 LTV loans made to borrowers with 570 credit scores and 67 DTI's? What of the 90 & 95 LTV Interest Only loans made to flippers? What of the 90 LTV Stated Income loans (many made to flippers)? What about the LTV's being based on stretched and hyped appraisals? What about the mortgage company "art departments" which cranked out custom W-2's and paystubs to document loan files with? What about all of the high LTV loans made to people with 50% DTI's and no money in their checking accounts? And how do you square it all with a huge and growing percentage of mortgaged homeowners who are underwater- far too many of whom are (or soon will be) unemployed or making substantially less than what they were? Then to top it off, one can only shake their head when it comes to REO disposition practices. Bottom line, I think any model must attack the assumption that the GSE's book of traditional business is solid stuff. Unfortunately, Fannie & Freddie were aggressive hedge funds operated to generate executive bonuses, and under the supervision of a defanged regulator. I'm afraid that when the tide finally goes out, it will not be a pretty sight.

I will deal with this in a modeling context, but then also in specifics. My model, which just assumes that defaults in the 2006 and 2007 vintages follow a curve with a similar shape to the 2000 vintage, makes no assumptions whatsoever about the content of the book. It just looks at the 2006 book, notes that it is currently defaulting at 2.8 times the rate of the 2000 book, that the difference between the 2006 book and the 2000 book is expanding, and hence the end default may be 4.5 times the 2000 book. Essentially, though, I am assuming that because things are getting worse they are going to continue to get worse.

One thing, however, is generally true about the mortgage market: The very bad loans default fast in a crisis, and then the defaults from that pool ease up, whereas good loans default slowly and defaults do not ease up for a long time. That is consistent with simple models of human behavior. If you have a 100% LTV loan that you purchased on a property you intended to flip in the Inland Empire then you have probably walked already. Why? Because the incentive to keep making the payments on a cash-flow negative property is very low. You will probably pocket three months rent while the bank actually gets around to foreclosing on you, but your motivation to pay is low.

If, by contrast, you are a regular mom and pop buyer who purchased a home to live in and put down even 10% (which you saved by dint of hard work), then your incentive to walk away is low. You have emotional investment in the property even if your financial investment is wiped out. The incentive to pay (because you do not want to be forced to move) is high. Moreover, there is a real tendency to self delusion as to the value of the property, and self delusion lowers default rates.

If a book consists of flippers and 100% LTV loans, then the defaults will be front-loaded. My model assumes that the defaults are rear-loaded. The more there are the drossy loans described by Bob, the more the defaults will be front-loaded and the more my loss estimate is thus an overestimate. If Bob were right I would be more comfortable with my estimates, not less comfortable.

Unfortunately, despite the protestations of Bob and others, there are actually relatively few truly risk-layered loans in the traditional books of Fannie and Freddie. For that I need to explain risk-layering. Consider the following three loans:

Loan A is made to a customer with terrible credit (a FICO of 580, reflecting past defaults). However, the customer has clearly reformed and now holds a stable job, which you have verified. The customer has saved $25,000 and is buying a very low-end property (say $130,000) in a nonbubble state. This is a low-FICO loan or a loan to a subprime borrower, but with otherwise good characteristics.

Loan B is made to someone with pristine credit and a stable income. You have verified that the income is more than adequate to serve the loan. The family has emotion invested in the house as the house is near the school in which the parents enrolled their children. However, the down payment is only 3% because the equity the family had saved was spent on recent medical problems. This is a high loan-to-value loan, but with otherwise good characteristics.

Loan C is made to a customer with terrible credit (a 580 FICO, reflecting past defaults). The customer has stable income, which you have verified, but is purchasing a $250,000 home with a down payment of only 3%. There is little evidence in customer's past behavor that that he or she is capable of saving money for a rainy day. This is a risk-layered loan in that it has two major risk factors: a subprime borrower and a high loan-to-value ratio.

Among these three loans, A and B are probably both good under almost all circumstances. The first borrower shows little record of past willingness to pay a loan, but in this case he or she has a real incentive to pay and the ability to pay. The borrower probably will pay. The second borrower shows a very good willingness to pay and the ability to pay, but the incentive to pay (being the remaining equity in their home) is low. Nonetheless, the borrower has an emotional commitment to the community and foreclosure is a difficult option.

Loan C is terrible. It was made to a bad borrower who lacks incentive to pay.

The collapse in underwriting standards that occurred in America was due to risk-layering. Two risk factors are many times more risky than one risk factor. Fannie publishes a table showing how many of its loans have various risk factors:

Fannie Mae Credit Profile by Key Product Features

From this table you can estimate how many of the loans have multiple risk factors. If you add up the special risk factors you get $1.112 billion. However, the actual dollar value of loans with a risk factor is $878 million, and those loans are 72% of losses thus far.

The numbers also suggest that at most, $233 million have more than one risk factor. That means less than 9% of Fannie's book has risk-layering, but my guess is that that small percentage of loans will be about 40% of losses.

The point is that the proportion of losses from risk factor loans is now declining (consistent with the argument above). It is loans without risk factors (the heart of the traditional Fannie and Freddie business) which is going to show increasing losses.

Fannie gives some data on loans with two risk factors, separately breaking out loans with a FICO of less than 620 (which means the borrowers are truly subprime) and with an LTV of more than 90% at origination. There are only $25.4 billion of these -- 0.9% of the book. However, these loans represent 5.7% of all losses. They are more than six times as loss-intensive. Note that the proportion of losses coming from this pool is falling, probably because the loans have a tendency to default fast -- you get loss burnout. The subprime loan pool -- 0.3% of books but 1.1% percent of losses -- has had even faster loss burnout.

Anyway, contrary to Bob's email, my estimate is more likely to be an underestimate precisely because there is not that much risk-layering in Fannie's book. If the losses burn out fast then they are not likely to rise far from current loss levels. If the losses burn out slowly (which is what would happen with lower-risk mortgages) then loan losses could rise for a long time as families slowly burn through their financial resources trying to keep current on their mortgages.

I am fairly confident about my estimate of credit losses at Fannie and Freddie. They are manageable, and the end loss to taxpayers is highly unlikely to be large. I am much less confident that the income line (which has expanded greatly) can remain so generous. And for the losses to taxpayers to be zero I need the companies to be able to earn their way out of their current predicament. I need the current large operating income to continue, or at least not to drop suddenly.

The sustainability of operating income 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.

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