Tuesday, September 09, 2008

Freddie Mac and the "Two Year Rule"

by Tanta on 9/09/2008 10:53:00 AM

People keep sending me this article or bringing up this "fact" in the comments. Because it is such a fine example of a "fact" that isn't actually a fact, but is apparently becoming an article of quasi-religious faith in some quarters, I shall make the attempt to slap it down. I have no particular illusions about how well this will work, but there may be a handful of people who actually care about accuracy and good faith, even (!) when the subject is Freddie Mac. I'm talkin' to you.

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Let me start out with a couple of general observations. This post is about financial accounting matters. If you are one of those people who drove us insane in the comments to yesterday's post on "assets" versus "liabilities" by arguing that "assets" are "really" "liabilities" because you, like Humpty Dumpty, are The Master, then you will find this post unsatisfactory. Tell it to the Marines. The habit of refusing to use standard accounting terms in preference to sloppy "synonyms" is what got these two reporters in trouble in the first place. I'm not going to pander to anyone by doing it myself.

Second, we basically went through a nearly identical version of this brouhaha last November with Fannie Mae. It's deja-vu all over again.

The offending "fact" comes from this article by the world-renowned Gretchen Morgenson and Charles Duhigg, whose willingness to believe anything any unnamed source says about Freddie Mac, whether it makes sense or not, has been documented before on this blog.

Finally, regulators are concerned that the companies may have mischaracterized their financial health by relaxing their accounting policies on losses, according to people familiar with the review. For years, both companies have effectively recognized losses whenever payments on a loan are 90 days past due. But, in recent months, the companies said they would wait until payments were two years late. As a result, tens of thousands of loans have not been marked down in value.

The companies have injected their own capital into pools of securities containing these loans, arguing that their new policies are helping more borrowers. Under conservative accounting methods, changing these policies would not have any impact on the companies' books. However, people briefed on the accounting inquiry said that Freddie Mac may have delayed losses with the change.
What follows is my best effort to discover what the hell these people are talking about. I must disclose to you all that I am really just making an educated guess here. If you possess any expertise at all in financial accounting in general and Freddie Mac's business operations in particular, the foregoing paragraphs do not make any sense whatsoever. (It's like talking to people for whom "asset" "really" means "liability.") So I could be wrong, and they could be talking about some entirely different part of the balance sheet. Anyone with a better guess than mine is hereby invited to share.

My theory is that they are talking about optional repurchases of MBS loans. I cannot think of or find any other part of Freddie's financial statements in which that "two-year rule" or this thing about "injecting capital" would fit. And if they are talking about optional repurchases, they're guilty of terrible reporting. Either their sources are badly informed or they didn't understand what their sources told them or both.

To review the basics of what Freddie does: they buy mortgage loans on the secondary market. These purchases of loans result in two different "portfolios" of loans: the "retained portfolio" and the "guarantee portfolio." The retained portfolio consists of loans and MBS that are owned outright by Freddie. That means Freddie's capital is invested in these loans. Freddie gets the capital to invest in the retained portfolio in large part by issuing notes and bonds--what everyone calls "agency debt." The retained portfolio constitutes an "asset" on Freddie Mac's books (net of the loss reserves), and the debt-funding constitutes a "liability" thereon.

The "guarantee portfolio" consists of various MBS that Freddie guarantees the credit risk of, but does not invest the capital in. The capital to fund these securities is provided by investors who buy MBS. Therefore, the total principal amount of the guarantee portfolio is not an asset on Freddie's books (it is an asset on the MBS investors' books). What shows up on Freddie's balance sheet is the "guarantee asset," which is the fair value of the guarantee fees received, and the "guarantee obligation" (over on the liability side) which reflects the fair value of the projected credit losses.

This distinction between retained and guaranteed portfolios is one reason why Freddie's (and Fannie's) financial statements are complex; each part of the "total portfolio" has different accounting treatment. If you read through these financial statements or any reports having to do with portfolio balances or loan purchase volume, you simply need to pay attention to when a number is given for the "total portfolio" versus one or the other parts thereof. To answer a question that may arise at this point, as of June 30 the principal balance of Freddie's retained portfolio was $792 billion and the guarantee portfolio balance was $1.410 trillion, making a total portfolio of $2.202 trillion (see Table 49 of the 10-K).

So. How do loans get into the retained portfolio? They are either originally purchased as portfolio investments or, in some cases, they were originally purchased in the guarantor program but had to be repurchased out of the MBS. As I said, the current flap seems to be about repurchases of MBS loans. I am going to quote here from Freddie Mac's 10-K. It will help you to know that "PC" means "Participation Certificate," and is just Freddie-speak for "MBS."
We also have the right to purchase mortgages that back our PCs and Structured Securities from the underlying loan pools when they are significantly past due. This right to repurchase collateral is known as our repurchase option. Through November 2007, our general practice was to purchase the mortgage loans out of PCs after the loans became 120 days delinquent. Effective December 2007, we no longer automatically purchase loans from PC pools once they become 120 days delinquent, but rather, we purchase loans from PCs when the loans have been 120 days delinquent and (a) the loans are modified, (b) foreclosure sales occur, (c) the loans have been delinquent for 24 months or (d) the
cost of guarantee payments to PC holders, including advances of interest at the PC coupon, exceeds the expected cost of holding the nonperforming mortgage in our retained portfolio. Consequently, we purchased fewer impaired loans under our repurchase option for the three and six months ended June 30, 2008 as compared to the three and six months ended June 30, 2007. We record at fair value loans that we purchase in connection with our performance under our financial guarantees and record losses on loans purchased on our consolidated statements of income in order to reduce our net investment in acquired loans to their fair value.
Remember that the "guarantee" on the MBS means that Freddie Mac is responsible for passing through interest payments to bondholders as long as those bondholders have principal invested, whether the borrowers make payments or not. The way this usually works is that for the first 90 days of delinquency (120 days since last payment), the servicer is obligated to advance scheduled interest and principal to Freddie Mac, who passes it through to the bondholders. The servicer makes efforts to collect the past-due payments from the borrowers. Generally at around 90-120 days, if the loan is still delinquent, the servicer's obligation to advance payments stops and Freddie Mac is the one obligated to advance payments to the bondholders. The basic contractual terms of the MBS are that Freddie has the right, but not the obligation, to buy a seriously delinquent loan out of the pool at this point. The repurchase price would always be par, since the bondholder must receive 100% of principal invested per the terms of the guarantee. Obviously, a seriously delinquent loan is likely to have a fair value of much less than par, but Freddie has to take that loss, not the MBS investor.

However, that is an option, not an obligation. Alternatively, Freddie can allow a seriously delinquent loan to remain in the MBS, while continuing to advance payments to the bondholders, until foreclosure or modification, for up to two years. To my knowledge the two-year limitation has always been part of the MBS rules--it's just the outside limit on how long Freddie (same for Fannie) can keep advancing on delinquent MBS loans before they have to give up and repurchase them. There have never been many loans that are seriously delinquent for two years without ever getting to foreclosure or workout, but in the strange cases (probate, bizarre title problems) it can happen. In no sense is this "two year rule" about letting loans just stay delinquent with no action by the servicer or Freddie Mac, or no effect on the fair value of the guarantee obligation, for two years. It absolutely does not mean that no credit losses are taken until a loan is "two years late." The two years refers to how long a delinquent loan can stay in the MBS, not how many months past-due it can be before it is impaired.

Why would Freddie elect to repurchase a loan when it doesn't have to? Well, if the cost of capital is cheap, but the interest payments you have to advance to the bondholders are not, it generally makes sense to repurchase the loan. The loan balance then comes out of the "guaranteed portfolio" and into the "retained portfolio." The write-down of the asset occurs immediately, given that the purchase price of the loan was par (100% of unpaid principal balance) but the fair value of a seriously delinquent loan is less than par. So a loss is immediately recognized by the retained portfolio. On the other side of the books, the guarantee asset and obligation are adjusted to reflect the fact that this loan is no longer earning a guarantee fee or reflecting guarantee costs. Any final loss taken on the loan in foreclosure is taken on the retained portfolio side, not the guarantee side.

On the other hand, if the cost of capital--Freddie's borrowing cost, including capital reserve requirements--is expensive, but the interest payments to be advanced to bondholders are relatively cheap, then you leave the loans in the MBS unless and until you are obligated to buy them out, which would be when they are delinquent and they are modified, foreclosed, or hit that two-year limit. If the loans stay in the MBS, they rack up those costs that go into the guarantee obligation, but they do not result in a recognized loss to the retained portfolio because they are not in the retained portfolio.

Now, go back and reread the Morgenson/Duhigg version of this and see if it strikes you as a reasonable paraphrase. As you do this, ask yourself if you've read anything lately in the news about Freddie needing to increase its capital reserves and facing much higher borrowing costs than it had previously. Then ask yourself if this all might be about not "injecting capital" into "pools of securities."

Of course this election not to buy out every seriously delinquent MBS loan means that fewer losses have to be recognized in the retained portfolio. The whole damned idea is to keep these loans in the guaranteed portfolio instead of the retained portfolio. However, it certainly doesn't keep Freddie from having to pay interest to bondholders every month, whether paid by the borrower or not. It still has a major effect on credit losses. It simply keeps the loans' principal balance "financed" by MBS bondholders instead of by Freddie Mac.

Has that been a wise move by Freddie? Well, I don't know we could answer that question in Morgenson/Duhigg terms, since they seem to think that the only "losses" that can be taken are in the retained portfolio. You would have to analyze the effect of the interest advances to the guarantee side of the books to see if this was a smart move or not. But of course Morgenson and Duhigg have no intention of doing that--I suspect they fail to grasp how one might do that--because to do so interferes with the narrative of "cooking the books" that they're peddling.

The interesting question that will arise, of course, is what will happen to this repurchase policy post-conservatorship. Will the government order Freddie to start buying out every delinquent MBS loan at 90 days down--knowing that the government might have to provide the capital for them to do that--in order to book retained portfolio losses "promptly," or will it perhaps decide to let the bondholders continue to finance these loans, just as Freddie has done? I'm really looking forward to finding out, myself.

At any rate, if one more person starts bringing up this canard about "no losses until the loan is two years past due" in the comments, those of us who are actually paying attention are going to jump your case for--wittingly or not--spreading stupid. You gotta stop believing everything you read in the paper.

I am the kind of person who wants to read a long post about financial accounting issues.