Modelling Fannie Mae and Freddie Mac – Part V
In Parts I to IV of this sequence I explained where the losses already realised at Fannie Mae and Freddie Mac came from – and where future losses might come from. I showed that the companies have almost reached reserve adequacy – a conclusion diametrically opposed to the consensus view that these companies are hopelessly insolvent even to the point that they threaten US government solvency. On losses the consensus appears to be simply wrong.
In this post I show how the revenue of the GSEs is up very sharply.
No competition
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 US mortgages has almost entirely disappeared. They are even allowed now to do jumbo mortgages.
Lack of competition means fat margins – and just as the revenue at Bank of America rose sharply during the crisis so does the revenue at the GSEs.
Here is the quarterly sequence of net interest income for Freddie Mac. The numbers for Fannie are similar…
Quarter
Net interest margin ($ millions)
2007 Q4
774
2008 Q1
798
2008 Q2
1529
2008 Q3
1844
2008 Q4
2625
2009 Q1
3859
2009 Q2
4255
The growth in these numbers is breathtaking. Operating costs are roughly flat. You would think they are rising because foreclosure and credit management (which costs Freddie money). However I suspect that those 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 pre-tax, 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 II and the explanation is technical – I do not feel the need to repeat the explanation here.)
Further Freddie Mac in particular has been an astoundingly good judge of when to hedge out duration risk. I wrote a post a while back about just how good Freddie’s trading has been. The seemingly superior interest rate risk management at Freddie has continued – though I would not bank on profits from that being permanent.
That said – the pre-tax, pre-provision profits at Freddie are probably going to run about $15 billion per 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 per 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.