graphic: Mike Licht, NotionsCapital.com via Flickr

graphic: Mike Licht, NotionsCapital.com via Flickr

Fannie Mae and Freddie Mac have already lost billions on transactions with bankrupt financial services firm Lehman Brothers. Now a new potential Lehman loser has surfaced, Stuyvesant Town, a deal sponsored by real estate giants Tishman Speyer Properties and BlackRock Realty. They are going to turn over the keys, having defaulted on billions of dollars in debt. Tishman Speyer and BlackRock only lose their initial investments of $112 million each, not counting any management or other fees they might have ripped out of the deal. Their investors, on the other hand, are going to eat billions in losses. Among those investors are two California pension plans — CalPERS, $500 million, and CalSTRS, $200  million — and a Florida pension plan, $250 million.

Fannie Mae and Freddie Mac are two of the largest investors, with at least $1.5 billion in commercial mortgage-backed securities, called CMBS. Here’s how the CMBSs were created. The deal was financed in part by Wachovia Bank, which took a $3 billion first mortgage on Stuyvesant Town. Wachovia sold that note and mortgage along with notes and mortgages on other commercial real estate to a single purpose entity (SPE), like a trust. The SPE raised the money to pay for the various notes by selling debt securities to investors. The notes are the only assets of the SPE, and the only source of returns to investors. In this case, there are several different classes of debt securities, which are called tranches, with different rights to payment from the money the SPE gets from the notes. The most senior tranche gets paid before the others, but has a lower interest rate. The other tranches get paid in order after the senior tranche, but have higher interest rates.

Neither Fannie nor Freddie responded to my inquiries about projected losses on the CMBS. According to the Wall Street Journal, Freddie Mac doesn’t expect to lose any money because it holds the most senior CMBS tranche. It’s not obvious that there won’t be a loss. The property is apparently worth no more than $2 billion. We don’t know how the CMBS documents allocate losses to the various slices, so we can’t verify that Fannie and Freddie won’t be eating another loss. Freddie Mac is reportedly willing to finance a new purchaser, which would certainly be one way to prevent the appearance of a loss.

These CMBSs are a legacy from the failed Lehman Brothers, which underwrote this transaction. Fannie Mae also did a bunch of derivative transactions with Lehman, and looks to lose over $120 million on those transactions, net of collateral, according to its proof of claim. Freddie Mac lost $1.2 billion when Lehman defaulted on an overnight loan as it filed bankruptcy. Freddie is in a loss position on derivative transactions with Lehman, to the tune of $17 million. The two also have claims arising from mortgages they bought from Lehman, totaling nearly $2.6 billion.

That last category is instructive. Those claims arise from the contracts between Lehman and Fannie and Freddie. Here’s an example from Fannie’s proof of claim:

Under the [contracts], if and when the aggregate principal balance of the mortgage loans which are ninety (90) days or more delinquent exceeds forty-nine percent (49%) of the aggregate principal balance [Lehman] is obligated to repurchase a sufficient number of delinquent loans to bring the delinquency rate to 49%….

Exhibit A, p. 2. They only protected themselves if half the loans went into default? Stunning. Fannie and Freddie think they will get pennies on the dollar of this debt.

What lessons can we learn?

1. Derivative transactions cost taxpayers a fortune. But bankers are plunging back into that business, so we get another chance to bail them out.
2. It’s okay for Tishman-Speyer and BlackRock to walk away from their mortgages. It’s not okay for homeowners to walk away from their mortgages, even in states where there are no deficiency judgments.
3. It’s okay for government-sponsored entities to buy junk CMBSs so Wachovia and Tishman-Speyer and BlackRock Realty can make money. Helping homeowners creates moral hazard.

I’m sure Ben Bernanke and the other true-believing free marketers will explain why this all makes sense.