Fannie Mae: Exit Stage Left
If you are not being compensated to take risk, then do not take risk.
In a recent speech given by the current Chairman of the FOMC, Ben 'Boom Boom' Bernanke - or 'Helicopter Ben' - spoke about GSE's (Government Sponsored Entities) like Fannie Mae (FNM) and Freddie Mac (FRE). These entities have an 'implied' backing of the U.S. Government.
The markets have always operated under the assumption that they were 'too big to fail' and have been treated similarly to GNMA, which actually has the 'full faith and credit backing' of the U.S. Government. Interestingly, the yield spread (relative to Treasuries) between GNMA (Ginnie Mae) and FNMA (Fannie Mae)/FHLMC (Freddie Mac) has been very tight, something on the order of 10 basis points, or 0.10%.
But I sense a sea change, particularly as it relates to Fannie Mae. Recall that the company's accounting was so confusing that it took the better part of three years to report audited results (the company's stock trades publicly under the symbol FNM). The market breathed a sigh of relief when FNM reported earnings, restated past earnings and put investors' concerns at ease.
Now, enter Chairman Bernanke and his recent speech (I actually read it three times to be sure I read it right). Most of the speech was in relation to the sub-prime mess. Now that the news is out (the cart has left the barn), regulators are all over it. In my humble opinion, they should have tightened lending standards long before this ever occurred. But that is not how bureaucrats operate in my experience.
Banks and mortgage lenders were lending with barely any reasonable standards at all. This all helped to build a bubble in residential real estate, which I think is nowhere near from over. In order to keep the bubble growing (after all, the US an asset based economy so it NEEDS asset prices to rise), lenders were encouraged to lend, even if the loans had a high probability of defaulting.
Well now, according to the 'implode-o-meter' at www.mortgageimplode.com, 41 sub-prime lenders have gone bust so far in 2007. Some of them are rather large. Further, it is estimated by the Mortgage Bankers Association that 2,200,000 homes will be foreclosed on in 2007 alone. Add this to the enormous amount of supply in the market already and falling prices and you can see that the supply/demand is out of balance. Further, homebuilders have levered their balance sheets and are loaded with inventory. This is NOT a recipe for a housing recovery; rather it is a recipe for a prolonged housing mess. To be frank, after reviewing the balance sheets of many homebuilders, I would not be surprised if some of them actually went bankrupt. That might actually be the event that causes a bottom in markets. After all, markets usually bottom when a large financial failure occurs. For example, the subprime market bottomed just as the second largest subprime lender, New Century (NEW), was delisted and is now basically bankrupt. In the industry, we call these 'watershed events.'
So what to do? We have seen when risk was 're-priced' in the lower end of subprime ABX indices-prices plummeted by 40% in a matter of weeks. It is why my firm is taking zero credit risk. I live under the following assumption in all asset classes: If you are not being compensated to take risk, then do not take risk. So, is Fannie Mae risky? Well, I truly do believe it is in the 'too big to fail' category, so that is not what bothers me. But what does bother me is the complacency in the pricing of its securities, many of which I have owned for the better part of 15 years. I will sum up what Bernanke said in his speech here:
- GSE's need to shrink their balance sheets.
- GSE's need to lend to those that need credit, which is why they were set up by FDR in the first place.
- They are not too big to fail.
- He thinks the company's securities are overvalued.
- He doesn't understand why the market ignores the risk as it relates to housing and thinks it should trade like other financial assets, like bonds of major banks.
Well, I guess you get my point. So here is what my firm is doing. We accumulated a lot of FNMA ARM's (adjustable rate mortgages) as a bearish bet on housing. It was because I thought that as the coupons rose, the over-extended consumer would like to refinance but wouldn't be able to. This is indeed happening as the prepayment speeds (this measures, among other things, the rate at which people are refinancing) are collapsing. This seems counter-intuitive as the adjustable rates (most of the bonds my firm owns are 7%+ coupons) are far above fixed rate mortgages which are in the 6% area. Why are these folks not re-financing? Because they can't. As prices of homes fall, or even don't rise, and because they have already extracted equity from their homes like an ATM machine, they cannot re-finance. In my humble opinion, this proves the bearish case for housing is upon us. And it will eventually reach into the financial sector at large and explains why my firm is so defensive from a credit perspective.
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