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Time Bomb



Yesterday these comments came out of testimony to Congress' subcommittee on GSE regulation:

"The company has missed deadlines, provided incomplete data and delayed in making employees available to the Office of Federal Housing Enterprise Oversight in a broad investigation of Fannie Mae's (FNM:NYSE) accounting practices, Director Armando Falcon told reporters."

As the government delves deeper and deeper into the company's accounting practices, I think company management will become even more feisty in their stonewalling on new rules and regulations being talked about to control the mortgage giant. Why? Because the company's business model (and management knows this) is faulty at best and a time bomb at worst.

The market, thanks to convention and conditioning, has come to believe that FNM is a government institution with its full backing. As a result, the company borrows from the market at basically the risk-free rate because the market perceives no risk. But several administration officials, including Treasury Secretary Snow, have remarked that the GSE's are not backed by the government.

Without this implicit guarantee, the interest rate FNM (and Freddie Mac (FRE:NYSE)) would have to borrow at would rise. Based on the size and leverage of the company and the risks that they take, this premium to the risk free rate would likely be sufficient to wipe out the ability of the company to make any money. Combine this with the risks that the company takes, and the business model is flawed.

So the company will do whatever it takes to maintain this illusion; the stakes are just that high.

I am assuming that our leaders in Washington, at least some of them who are responsible for financial regulation, must understand the magnitude of the risk to the system if FNM fails (although I may be wrong on that for these are the same people that repealed the Glass-Steagall). What would cause the company to fail? Not much. The leverage is so great that it could come from a severe recession or maybe even just a rapid change in interest rates. FNM is Long Term Capital Management (LTCM) squared: at least LTCM had a diversified portfolio.

But our leaders do not seem to have the political will to tackle this problem. FNM is a particularly powerful institution, particularly because they get it from not only the haves, but also the have nots.

The fact that many constituencies would like to see FNM continue doing what they are doing does not make it any less risky and dangerous to the system. The situation is untenable in the long run.

Wall Street analysts are for the most part sanguine and bullish on the company's prospects. These are smart guys aren't they? Why don't they see any problems? FNM is without question not only the largest issuer of corporate bonds in history, but they are significantly more active traders of that debt, constantly recalling and issuing different durations. This is extremely profitable for our friends on Wall Street. Hmm.

Fidelity the mutual fund owns around 70 million shares or around 8% of the company.

And just to add icing on the cake, the GSE's are the only corporations that have the ability to create credit out of thin air outside of the control of the Federal Reserve. Money center banks get their direction on lending from the Fed's control over the Fed funds rate. FNM has no such control: they can issue as many bonds to buy as many mortgages as they want.

Normal corporations can grow revenues and profits without increasing debt, or doing so very little. FNM cannot grow without increasing debt. FNM's assets, mortgage debt, is larger than the market in which they hedge the risk of those assets.

FNM is able to justify an increasing balance sheet as long as home prices rise. We just learned that home prices in San Diego rose 32% over just last year. Can this continue?

Someone with a deep understanding of risk, and particularly convexity risk, should be allowed to assist the OFHEO in their accounting review of the company. I doubt the regulator really has the tools to understand the risks fully. Our leaders must somehow muster the political will to look at this situation correctly, before the bomb goes off.

The bomb is ticking, recorded in each tick of the bond markets.

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Position in FNM and FRE

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