Blessed by the Potato

Freddie Mac is one of the most ridiculous names I’ve ever heard for a business…

Stupid name aside, Freddie Mac is a Frankensteinian monstrosity of a company. Its main business is securitizing mortgages in the US: they buy a bunch of mortgages from banks, package them all together, then sell the bonds. The idea is that by buying the mortgages from the bank, the bank’s money will be freed up to make yet more mortgages, making it easier for Americans to buy homes. The investors in the bonds/mortgage securities get something reasonably safe to invest in — what are the odds everyone would default on their mortgage at the same time? — at a better rate than a government bond.

Of course, securitization is now a dirty word, because these sorts of schemes blew up so badly when subprime loans got into the mix. In Freddie Mac’s case, they made money by charging for insurance on these mortgage bundles, and they took on the credit risk. Things aren’t quite all that bad though since they didn’t get into the really nasty subprime dreck — for the most part, Freddie stuck to “conforming loans”. Nonetheless, Freddie got into some serious trouble last year as the housing and financial markets plummeted, and the US government took over, injecting capital at a cost of 10% per year (and that capital injection was larger than all the capital they had before — common and preferred equity — so that large dividend to the government is quite punitive).

John Hempton at Bronte Capital had a very long, very detailed, and — surprisingly — very interesting series on Freddie Mac, looking into their numbers, and suggesting that they were not totally worthless. If there is some value left in the company, then the preferred shares in particular should be worth something. I thought it was a very intriguing investment idea, but I didn’t have the time (or I fear, the ability) to reproduce his very thorough analysis (and importantly, to see where it might fail). I suspect not co-incidentally, the various preferred shares of Freddie jumped by about 40% after John published his analysis.

This week however, another analyst has stated that Freddie Mac is completely worthless, and the preferreds have fallen something like 25-30% in the last two days, which might make them worth looking at.

There are a number of different “series” of preferreds, designated by letters. The Z-series was the one issued most recently, and carries a variable interest rate of at least ~8%, and it’s also one of the most liquid. It has a face value of $25, and matures December 2012, or every 5 years thereafter — the option to redeem it is at the company’s discretion, not the investor’s. So, what that means is that this preferred share should fetch $2 in dividends every year, if the company is able and willing to pay them, and should be redeemed for $25 if the company is worth anything at all at some point in the future (or some fractional value thereof if the company is liquidated but has some value after the debt holders are paid). The dividends, right now, are not being paid. If the company, as the recent analyst says, is worthless, then these too are worthless.

However, if Freddie Mac does manage to turn itself around and pay the government back (and the government has to be paid first, even before the bondholders if my understanding is correct), and starts making a profit again, then a single dividend payment on these preferred shares would make you whole — indeed, provide you with a fairly decent return, even if that single dividend is a few years in the making. If the preferreds are redeemed for face value, then that would be a 20X return (times, not percent, since these are trading at about $1.25 today), though the timescale is unknown (they probably wouldn’t be redeemed at the 2012 maturity, but possibly at 2017). The first post in the series of Bronte Capital’s analysis his here — I recommend giving it a read even if you don’t plan on investing gambling on Freddie.

The payoff is huge, but of course the risk is also large. In particular, there’s the political risk of the US government not allowing Freddie Mac to continue as a going concern, and that political risk can come from the legislative side, or the treasury side (in having to support a $50B capital injection at 10%, or in being forced to reduce the size of their mortgage book). While I enjoyed John Hempton’s analysis, and I get what he’s saying that the worst of the losses are already accounted for, the other point of view has evidence too: Freddie currently has negative equity, and has to pay more than its net income in dividends to the government (but, not more than it’s pre-tax pre-provision income). With that punitive bailout, they might never be worth anything. But if they can repay the government, they do look to be generally profitable (at least on their core mission of insuring traditional mortgages), and could eventually be worth something someday. After all, the dividends owed to the preferred shares (if they are ever reinstated) are substantially lower than the interest they currently have to pay the government — so if they can get the government repayment off their back, the preferred shares should be worth substantially more than they are now. If they can’t… well, they’d be worth nothing. There doesn’t look to be a lot of middle ground.

If you do decide to invest into it — and I honestly can’t recommend it to anyone — then be sure to consider that money gone until 2017 at the earliest, and remember that this is a case where only investing what you can afford to lose definitely applies!

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“You can’t time the market” is a statement that’s generally true for the stock market — it’s a highly liquid, fairly efficient market full of professionals who all have roughly the same access to information about the future of the market. The shares traded are identical, so as soon as one is traded at a new price, effectively they’re all re-priced, and they’re only traded with the goal of making money — nobody hangs onto a share because it’s what they owned when their daughter took her first steps or because it’s customized just for them. The theory says that any information that could affect the future value of stocks is priced in in short order, so you can’t successfully time the market — getting out before a crash, or in before a surge. At least, not consistently enough to make money. And for the stock market, I think that’s probably true.

The housing market is a different beast entirely. It’s composed of units which are not 100% interchangeable. It’s highly illiquid. The participants are to a very large extent non-professionals who are poorly or even mis-informed about the state and future of the market, and have emotional entanglements to their properties on top of that. Each transaction is negotiated in secret, with pricing details only released some time later — so when one is traded at a new price that incorporates information about the future, it doesn’t necessarily affect other sales.

So when I come on here and piss and moan about how the housing market is getting ridiculous, and how I really fear that there will be a crash/correction to come in the next few years, and people say “you can’t time the market”, well, that’s not entirely true for the housing market, since it’s not as efficient as the stock market. It is true that I can’t say “next June, a month before the BoC’s promise to keep rates low runs out, the market is going to tank 8.53%”. It’s true that I’ve been bearish for over 2 years now, and aside from the beginnings of a correction last fall (a tailspin broken by the low rates), Armageddon has not visited Canadian homes. So in that sense the timing is hard. Getting the exact “when” down is very difficult. It’s certainly not precise. But it’s enough to know that we’re near the “top”, even if we don’t know when the “bottom” will come — the “when” is often not as important as the “how much”.

For the stock market, there is no “renting” of stocks. There’s no set of metrics that tell you reliably when the market is over- or under-valued. P/E ratios, bond yields vs dividend yields, these might be useful clues, but nowhere near as handy as the rent-vs-buy calculation. If a landlord can’t buy a place and rent it out at a profit, then something has to change. It’s also hard to come across telegraphed messages like this:

But if home prices keep bubbling, the central bank might raise rates

If the real estate market momentum does not moderate in the coming year – “or worse still, if price growth accelerates – it could lead to an earlier and more substantial tightening in policy than currently anticipated,”

Not often you’ll see hints from that the central bank is out to keep a bubble under control.

Of course, interest rates are a blunt instrument. There are many interconnecting factors: the dollar is already getting too high vs the USD, hurting our exports in a tenuous recovery. The central bank wouldn’t want to start raising rates to control the over-heated housing sector just to doom the business sector. Even within the housing sector, urban areas have the fever the worst; the Maritimes and more rural areas aren’t too far off of realistic valuations. There are more precise ways to throw water on the housing market, such as taking away 5%-down 35-year insurance.

In all seriousness, I don’t think people have to worry about the BoC jacking rates before their self-imposed timepoint of next summer, unless non-house inflation also takes off. However, the fact that this is on the BoC’s radar at all should be troubling. We are, IMHO, near the top of the market, even if the “when” of the peak may still be another year or two down the road.

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Somewhere out there, a friend-of-a-friend-of-a-friend has run into marital and financial difficulties. About 2 years ago they bought a house with ~<5% down and a long amortization mortgage. Today, they’re splitting up and have to sell the house.

Even if you plan to stay in your home for 7, 10, or more years, life happens: divorce or job loss/change can sneak up on you and you can find yourself needing to move. Even without considering a potential dip in the housing market, it can cost a good 7-10% of your home’s value to get out of it: an agent will take 4-6% as commission — a strong case can be made for selling on your own, but then you might still lose out on that much due to kicking back something to the buyer’s agent, and the fact that a buyer will expect to at least split the savings with you. The lawyers and any repairs/repainting you have to do to move it will take a chunk, as will land transfer taxes if you buy a new place (and capital gains tax if it wasn’t your primary residence). Your bank will also want a hefty fee to break your mortgage early, particularly if you’re not rolling over into a new mortgage with them. A house simply is not liquid: it can take weeks or months to sell, more months to close, and there are high fees for doing it when it does finally get done.

In this 4th-hand anecdote, the couple in question doesn’t have any savings outside their home, and in such a short timespan they’ve paid basically none of the principal back beyond that initial 5% downpayment. If they sold, they wouldn’t get enough money from the sale to pay back the mortgage and all the other fees.

They can’t afford to sell.

In this case they may default on the mortgage and let the bank foreclose. I don’t know if they tried to negotiate a “short sale” with the bank, to have the bank forgive the few percent shortfall if they sold now, but I doubt that option will be as popular in Canada as it has been in the US. After all, even after foreclosing and auctioning off the house, the bank can still come after them for the remaining money owed. If it’s substantial enough that the bank will go to the effort of suing, they’ll probably have to declare bankruptcy. They probably could have sold, lost their downpayment/equity, and worked out a payment plan for the remainder, but it doesn’t look like they consider their credit worthiness for the next decade to be worth that.

So, a lesson for all the would-be 5%-downers: be sure that if you get caught off-guard, having to sell, that you can come up with at least the extra money needed to cover the closing costs. You can call paying down your mortgage “forced savings” all you want, but nothing beats actual savings in a time of crisis. Also, consider that the first ~7% that you put into your home is not “equity”, but is actually lost to you forever, your selling costs pre-paid. A 5% mortgage then can be seen as a de facto negative-equity one.

A somewhat similar story was featured in the Globe this Saturday. It was focusing on the issue of involuntary part-time work, with the added wrinkle of a declining rather than flat housing market, but also highlighted that a job issue can force one to sell their home at a loss, and unless one declares bankruptcy, payments will still have to be made on the debt even if the house isn’t lived in anymore:

When he landed a well paying job at TransAlta Corp. in early 2008, running the electricity company’s computer systems, one of the first things Mr. Jones did was buy a house.

He wanted to live the homeowner’s dream, so he plunked down mid-six figures on a full-sized house in Calgary, which he helped finance with a salary that paid him a comfortable $120,000 a year.

It didn’t last long. Things took a turn in February when the slowing economy humbled energy prices and TransAlta, like many companies, began to slash costs. As one of the newest additions to the company, Mr. Jones, 57, was among the first to go.

Immediately, he began looking for work, but found little in the form of full-time opportunities. Instead, Mr. Jones was forced to pick up a few days of work each week to try to make ends meet.

“When you’re unemployed, people can catch you at nickels and dimes,” he said. “They know it when they have got a guy who’s probably worth a fortune, but he’s unemployed and he’s got a mortgage. So they offer him peanuts. And you take it because you’re scared. And because three days a week is better than no days a week.”

In June, unable to keep up with his mortgage payments, Mr. Jones sold the home in a hurry, in a slumping real estate market. The sale came at a considerable loss, forcing him to absorb tens of thousands of dollars on the mortgage. He now continues to make monthly payments, albeit smaller ones than before, on a home he doesn’t live in. “I was falling so far behind that they were going to take it anyway,” he said.

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Since I know some of you at least haven’t picked up a calculator since high school, let’s go through a very quick simplified calculation of mortgage interest and payments. Just looking at a very simplified version of the formula, your interest per month = principal due * (yearly interest rate / 12). Like I said, very simplified. So, if you have a $400k mortgage, and your interest rate is 2%, you owe about $667 in interest every month. If your rate goes up to 3%, that’s $1000/mo. At 4%, $1333 — double what 2% was, which is pretty obvious for this simple case. At 6% you’d be paying $2000/mo in interest, and at 8% $2667/mo.

Of course, that isn’t what your mortgage payment is, since you also have to repay some of the principal that you borrowed each month so that by the end of your amortization period (whether that’s 35 years or something shorter, like a more traditional 25 year period). Let’s say that you paid an equal amount back towards the principal each month. Without interest, that’d be 400k/(25*120) = $1333/mo. Of course, you don’t pay down your principal in equal installments: mortgages are generally set up so that you have a fixed payment for the duration, part for interest, and part for principal, so that at the beginning you’re paying mostly for interest, and at the end you’re paying mostly towards principal.

At this point we could continue doing the calculations by hand, but that’s going to detract from what I’m trying to draw attention to, so let’s instead make use of an online mortgage calculator:

At 3%,

• a 25-year mortgage has payments of just under $1900
• and at 35-years, payments of $1540.

At 5%,

• a 25-year mortgage has payments of $2340
• and at 35-years, payments of $2020.

So when the rates were dropped to the bottom during this financial crisis last year, a 35-year mortgage got roughly 24% cheaper. This, to a large extent, has been what’s keeping the Toronto market afloat this year. To me, that’s crazy, because those monthly payments are only low as long as the rates are — once interest rates go back up, so too will the payments. People at large though are short-sighted and focus on the monthly payments rather than the actual cost. But what’s more bizarre is this quote from the Star’s real estate section:

“Those are very robust numbers,” said Toronto housing analyst Will Dunning. “Part of this seems to be fuelled by the fact that some buyers fear interest rates will go higher next year and are buying now rather than taking a chance on next year.”

If you fear rates will go higher next year, why rush to buy now? In Canada, you can’t “lock in” a low rate, at least, not long enough for it to really matter. While you might be able to find a lender that offers a 7- or 10-year term, for all practical purposes the longest you can lock in your rates for is 5 years. Five. Short. Years. And to lock in for that long, you often pay a premium rate, which largely factors in modest rate increases anyway. Right now you could probably get a variable-rate mortgage for less than 3%; a fixed 5-year would be over 5%. A 2% increase in rates is already factored in, and you get to start paying that right now. What is locked in?

Your principal.

The amount you actually pay for the house. 5 years from now when it’s time to get a new rate, you’ll have paid down… not very much on your 35-year mortgage. You’ll still owe about $375k of your original $400k if you had the 5% fixed rate — barely 6% of your house is paid off after 5 years. You’re still just as vulnerable to rates going up, since your principal is still virtually the same. If rates did go up, people focused on that monthly payment would probably bid less for a home, since they couldn’t afford any more (even with the low rates, we’re at the bleeding edge of affordability in Toronto) — this is why house prices generally move opposite to interest rates (as rates go up, prices come down).

Unfortunately in our world of cheap debt and rules of thumb, people mostly pay attention to this monthly figure, in the here and now, and think little of what the future might hold and how they might need to manage their risk. And we are at (or very close to) the point of maximum risk here: housing prices can’t go up forever. After all, someone has to keep buying, so everyone can’t be priced out forever. More importantly, interest rates can only go up from here. The overnight rate from the Bank of Canada is essentially zero right now, and bond yields are low — mortgages will not get any cheaper. And just as lower mortgage rates made the monthly payments lower for buyers, higher rates will make them, well, higher. Much higher.

So we return to the case of the forced savings, those unfortunate individuals (and yes, this describes some of my friends) who simply can’t manage to budget and save, so by buying property and paying down the mortgage they’re building equity, a forced savings program. However, if they’re already pushing the boundaries as it is, living hand-to-mouth, what happens if rates spike? If they don’t have the financial discipline to live as though rates were higher, and save the difference in good times, will they really (as they tell themselves they can) be able to tighten their belts and avoid foreclosure when rates really are higher? As you can see with the mortgage calculator, it doesn’t take very much change in rates at all to really affect the monthly payments you have to make. If it looks like things might get bad if we return to the ~6% rates of this decade, what about going to the 8% average rate of the last 20 years? Or spiking above 10% like in the 80’s and early 90’s? [At 8%, that 35-year mortgage goes from $1540/mo to $2841] Extending the amortization, going from a 25-year mortgage to a 35-year one can also reduce payments, as you can see above (~15%). Having the freedom to refinance into a longer amortization mortgage can be a good safety valve in the case of a temporary spike in interest rates, a problem with your job, etc. However most first-time buyers are going straight for the longest amortization they can get, so their ability to lower monthly payments has already gone straight into higher housing prices (and that price increase is probably permanent, as long as government policy allows for such ridiculously long amortizations).

The last shred of hope is that even though rates can only go up, they can take their sweet time getting there, with the example of Japan used to showcase how rates can be kept low for a very long period of time. However, the Japanese scenario is not likely to play out again here IMHO. There are a few reasons for that:

Japanese society valued having large cash savings. These deposits were psychologically sticky — the Japanese consumer, despite earning no interest on money sitting around, and having a very easy time of borrowing money, was not much interested in spending to stimulate the economy. Westerners, on the other hand, love their 0% financing car loans/leases, and get fed up with GICs that yield less than 1% after tax and look to deploy their capital elsewhere. Rates don’t have to stay low for nearly as long to have the desired effect of stimulating spending.

Japan was experiencing a bank crisis, but almost the reverse of what happened in this financial crisis: the banks were not solvent, but had plenty of liquidity, thanks to the savings of the Japanese housewives. The low rates for such a long time was their bank bailout. Because the debt markets can still demand a premium from banks to loan money (while deposits are generally the cheapest form of funding), it doesn’t matter too much to recapitalizing Western banks what the interest rate gets set at, as long as they can make their spread (unlike the Japanese in John Hempton/Bronte Capital’s example, zero rates does not translate into free funding for them).

There was competition for lending in Japan, squeezing margins. For a while, that was happening in the US, which is part of what brought on the crisis — margins no longer allowed for reasonable loss provisions, let alone profit. In Japan, the lack of a decent margin meant rates had to stay low so that the banks could be cash-flow positive, and they had to stay low for so long because everything was so inter-connected that the banks didn’t want to foreclose on heavy industry borrowers or golf courses that they actually owned themselves. In the US now, the foreclosures have happened, the bubble has burst, the write-downs are taken, and where needed, the taxpayer bailouts have been made. In the west, everyone is eager to borrow, and margins have been getting fatter as the banks use every excuse related to the crisis to hike fees (and also take advantage of the flight to safety to lower the margin paid for deposits, though the opposite happens at banks perceived as being riskier). Once we’re sure the risk of deflation is gone, it’ll back to business as usual.

Even if the Bank of Canada kept the overnight rate near zero for a long period of time, mortgage rates might still go up, since the bond markets that actually supply the funds to the banks can move independently of the central banks.

The housing market needs rates to stay at zero to stay stable; the banks probably prefer lower rates, but they’ll survive with higher ones. Inflation could loom for the rest of the economy though if rates stay too low for too long, and that is what the BoC is out to control. Low borrowing costs also tend to encourage leverage which leads to bubbles elsewhere…

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There was something of a movement afoot in the previous decade towards people having their heads (or for the very wealthy, their whole bodies) cryogenically frozen after their deaths. Partly in the hopes that someday, in the distant future, science (or advanced voodoo) may find ways to conquer death, and cure whatever it was that killed (or for those frozen just before their deaths, would have killed) them.

The concept always seemed just a little half-baked: after all, what use would the immortal demigods of the future have with the head of a frozen neanderthal such as yourself? Odds were good that if you were thawed, it would be purely at their whim, and you would have to spend the rest of eternity doing parlour tricks for them and their dinner guests, or spend mere hours running in terror through the last remaining forest preserves on an otherwise entirely urbanized planet as you serve as human prey in their safaris. Or perhaps they’d launch you deep into space, for future generations of explorers to defrost and gain valuable insight into what life was like in the barbaric 20th century.

Some of these real-world tangled issues of waking up a thousand years in the future were highlighted in the near-documentary series Futurama, which largely contributed to the downturn in the fad.

However, what if you still want to have your head frozen for posterity? Well, then it’s important to consider a number of issues, many of them scientific, such as what temperature will the service keep your head at, and how soon after death can it be frozen? Will there be an antifreeze/cryoprotectant solution of some sort to prevent crystallization, and what wards and charms will be placed on the cryotank to prevent zombiism (both rising as a zombie yourself, and also to prevent your bodiless brain from becoming zombie junk food)?

Just as important as how your head will be cared for is a consideration of how long it will be cared for. What is the financial health of your cryopreservation provider? Do they have a long-term plan? Is your one-time payment enough to provide an income stream that will see to your care in perpetuity, or is it set up like a Ponzi scheme, relying on money from new clients to keep the old ones frozen?

This last point has implications beyond just cryogenic head freezing: for anything that you will depend on for years into the future, especially something you pay for up front, what is the robustness of the organization behind it? Whether it’s a car that you might need warranty work on (though there is an implicit government guarantee behind most troubled automakers), or something without an explicit warranty, like a life insurance company or house, will what you’re buying stand up to the test of time?

The recession and financial crisis has served as a sort of shaking-out process for some of these companies. In the cryonic freezing space, I went back to an old article on it, and of 3 companies mentioned, 2 of them still have active websites (the 3rd hasn’t been updated since 2007, and even then many of the features have been “coming soon” since 2003, so they may have been a marginal player wiped out by the recession). According to the Wikipedia page on Cryonics, a number of smaller players have failed over the years, showing that it’s tough to find good help, especially after you’re dead.

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