Minyan Mailbag: Fannie and the Fed
Should I pick conundrum one, or conundrum two?
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
Thought #1: Whether or not Fannie Mae (FNM) is neutered by Congress, I still see it as likely to come crashing down to Earth. One problem is their extreme leverage and exposure to interest rate risk, but the main problem, as I see it, is their exposure to rising defaults. They make their profits by guaranteeing the revenue stream on mortgages, which is great during good economic times, but as the economy slows and the equity extraction craze inevitably yields to overburdened borrowers and greater defaults, Fannie Mae will be left as a major bag holder on the bad loans.
Thoughts #2-4: Let's just assume that the Fed's main purpose is to increase the profits of JP Morgan Chase (JPM). Of course it would be an interesting discussion as to whether that is their sole purpose, or one of their purposes, or just the effective result of their actions, or even if their actions disproportionately protect the interests of JPM at all... But let's just assume that is their main purpose and ask: What actions by the Fed in the recent past and in the future, with regard to Fannie Mae, would best serve JPM? We know that JPM is one of the biggest counterparties to FNM's derivatives hedges, and that JPM has taken on extreme levels of risk in order to generate extreme profits. Allowing the GSEs to grow wildly has meant wildly growing profits for JPM in the area of selling derivative hedges to the GSEs. However, the risk that the GSEs have gotten too big and could cause a meltdown in the derivatives markets could be behind the Fed's more recent desire to bring them under control.
The conundrum of the tightening yield curve and range bound long term yields have been highly profitable for JPM, as they haven't had to pay out much on the mortgage industry's derivative hedges, while profit margins are slowly squeezed throughout the mortgage-originating, revenue-guaranteeing, selling-off-to-foreign-official-accounts cycle of mortgage bankers and GSEs. Might JPM's best long term interests be served to see these upstart competitors gradually have the life squeezed out of them so that JPM can take a larger share of the origination and securitizaton businesses?
Rates did begin to shoot up in March, but now we're solidly back in "Conundrum Two" territory, again to the likely benefit of JPM. The Fed stepped up the hawkish tone during "Conundrum One", and they seem to be coming down hard on the mortgage industry now in Conundrum Two. Might the Fed offer support against falling yields if the JPM book becomes endangered by a continuing decline in yields? If rates move far enough, FNM takes some big losses as they have to reposition their hedges, generating profits for those who'd sell them those hedges. However, if they move too far, those (like JPM) who've taken on the greatest exposure to rate fluctuations would be the hardest hit. Has the timing of the Fed's tough talk/loose talk worked out conveniently so far so that FNM has felt the pain on either end of the interest rate fluctuations, while JPM has been spared?
Thoughts #5-7: Fannie Mae's stock has been moving up over the past month or so, but so have a great many heavily shorted stocks that were beaten down in the early part of the year. Indeed, this rally seems to have been largely led by by companies that appear to be obvious shorts for one reason or another. I don't think that Fannie Mae's situation has materially changed in the past month, only that the market has been going through one of its phases. Sometimes garbage floats, sometimes it sinks. Lately it has been floating. It's still garbage, though.
2005 has been a year of backfiring hedge fund strategies. Just as the growth of the GSEs has meant great profits for derivatives desks at firms like JPM but has created significant systemic risk, the growth of the hedge fund industry has meant great profits for the trading desk, while also creating significant systemic risk. The GSEs, hedge funds, mortgage bankers, rising short term rates... do I sense a pattern of credit contraction going on here?
To me as a casual observer, it seems like it has been "open season" on hedgies all year, with a sort of monthly sector rotation going on between strategies that are targeted for a spanking. May might have been the month where designated short funds and long/short equity funds got their hats handed to them, just as corporate bond funds, convertible bond funds, anti-dollar plays, and various interest rate plays had their turns to eat humble pie earlier in the year. When the tide will turn and the Going-To-Zero shorts (including FNM, in my book) will resume their slide is anybody's guess, but I suspect it won't be too much longer. If it is still open season on hedge fund strategies, which strategies might be next on the chopping block?
As always, I'd love to hear your own thoughts on these matters,
JPM is by far the largest derivatives dealer in the world and I am sure they therefore now have a "very close relationship" with the Federal Reserve. This seems to be part of the "socialization" or risk we mentioned yesterday. Just how close the Fed and JPM are is anyone's guess; your thoughts are certainly reasonable and are great food for thought.
My sense is that it is getting tougher for banks and broker dealers to make any money in traditional ways with a flattening yield curve and it is likely that JPM's derivative books are generating substantial "profits" to bolster capital. But that could turn on a dime if FNM were truly left to market forces.
JPM and FNM have become to me key stocks to watch.
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