Saturday, July 12, 2008

'Chuck, GSE's, Gold, and the Poor old shrinking dollar'

Does anyone like Sen. Schumer? Let’s set aside my personal distaste for the man as I have over the years become convinced that he just hates Arabs, and just focus on his utter incompetence as a public figure. This Harvard man(college and law school), Aipac member, DP World blocker, and all round publicity junky can now add bank destroyer to his long list of credentials. Last time we talked about Chuck he was trying to blackmail the Saudis into raising their oil production. His strategy worked and oil prices have done nothing but steam roll higher. If exacerbating an already tenuous oil situation wasn’t enough, he has decided to throw himself into the banking game. His much publicized letter to the FDIC Chairwomen in which he suggested they keep an eye on Indymac Banc probably caused the run that finally crippled mortgage lender and will leave some 19000 unlucky depositors wondering whether or not they will ever see their non-fdic insured funds. Honestly, I just don’t understand this guy. If he wrote this letter two years ago, I’d have some respect for the man. But writing it in the middle of a financial contagion? What is he thinking? Every regulator and his uncle is working overtime right now to make sure this crisis doesn’t get any worse…and along comes chuck shouting fire in a crowded theater. If this guy likes stampedes so much, maybe they should send him to the running of the bulls. Anyway, to pin the Indy failure entirely on chuck isn’t fair.(though I can’t see how his letter did anything other than publicly suggest the fdic do exactly what it was already quietly doing) When you build an entire lending business around no document loans your demise is your own doing, and the regulators are morons for not doing anything about this a long time ago. Honestly, what do we pay these guys for? Having formerly been an employee of Treasury I am starting to wonder whether or not the regulatory system will ever effectively regulate anything. Anyway, enough of chuck bashing for now…let’s move on to the Fannie/Freddie crisis.

Anyone watching these stocks on Friday must have been wondering what the hell is happening. Both where down over 40% at one point. Things have really gotten out of hand. Though I find some personally irony in this situation as I lost a good deal of money shorting these stocks a few years ago when Jim grant and company first started talking about their eventual demise… The thesis was so compelling, and yet nobody ever wanted to listen. Now, they are on the brink of disaster, and I find myself hoping that the powers at be find a solution to this mess. Why? Well, Fannie and Freddie are just too damn important. As the largest buyers of US mortgages, these firms are largely responsible for how the current US housing market functions. Any major disruption in their operations could be disastrous.

So what’s the problem? For those who have not being following this closely or for that matter don’t understand how these guys work ;I will provide a brief summary as I have spent a great deal of time studying these two companies over the years. Fannie and Freddie are Government Sponsored Entities(GSE’S). They were created with the express purpose of making housing more affordable. Fannie was one of FDR’s new deal initiatives to provide liquidity in the mortgage market, and for the past 70 years it has done precisely that. The company was turned into a private entity in the 1960’s, and it was joined by Freddie in the early 70’s. Their business model is simple. Fannie and Freddie buy or guarantee mortgages. They then sell bonds(agency debt) against securitized pools of these mortgages. They make money by charging a small premium for their agency guarantee. Which basically means that if the mortgagee behind a pool of mortgages defaults on principal or interest Fannie will guarantee that you are paid. These bonds are NOT backed by the US Government, despite the fact that most investors seem to treat them that way. The idea is that these guys buy high quality mortgages and as GSE’s can issue debt at a very low cost(a slight premium to treasuries). The business model worked for a very long time. But sometime in the late 90’s the mgmt of these firms got more aggressive as they sought to drive ROE. Whether they got too big or too careless(or both) depends on who you talk to… either way they started to come under fire. Both were hit with major accounting scandals, and both came under significant regulatory scrutiny. The temporary beating in their shares didn’t last very long though as the US housing boom provided enough of a tailwind to get them through the mess. Today, things are different. Both GSE’s are clearly going through some hard times as short term liquidity dries up while their giant pool of mortgages/and guaranteed mortgage obligations deteriorates. Many would argue that the companies are fundamentally insolvent. I tend to agree with this argument. When you consider the sheer size of their mortgage market exposure and the rising rates of delinquencies along with their equity capital, I find it hard to fathom that either of them can cover their near term obligations if they are adhering to US GAAP. So what should the US Government do?

1) Stay out of the way and see what happens. I.e. let them them fail. This option is off the table. The GSE’s cannot declare bankruptcy. It would be a financial fiasco. The agency debt market is huge and includes a long list of creditors that range from foreign governments to major pension funds and state and local governments. With all the different parties involved I doubt the creditors could ever agree on anything. Furthermore, the temporary disruption to the mortgage market would be disastrous. The GSE's account for nearly 40-60% of the market. Taking them offline even for a short while could send the US economy into a black hole. Mortgage rates would soar and housing prices would take another massive hit.

2) Put them in a conservatorship. This is an interesting option, and was discussed by the op-ed piece in the NYT on friday. The laws were amended in the early 1990’s to allow regulators to place either entity in a conservatorship if they were found to be ‘significantly undercapitalized.’ Since that appears to be the case, this seems like a very possible outcome. Under this scenario, the equity holders probably get wiped out while a team of regulators steps in to nurse them back to health. However, I don’t really understand how the funding issues would be solved. The dividend goes away and that saves some cash, but the rest will need to come from the FED. How much? I have no idea.

3) Nationalize them. Since Fannie and Freddie basically are sitting on close to $6 trillion in debt, this option is a tough sell. The Govt would have to issue treasuries to basically replace the agency debt. This would increase the public debt by over 60%. Not a very appealing thought for the already battered US dollar. They could of course just choose to expressly guarantee their debt instead and thus keep them as they are…but that would also basically have the same outcome for the dollar.

4) The government could take a controlling stake in both companies. This would provide much needed new capital and allow the Government to replace the board, change the mgmt, cut the dividend, and all the while maintain the private status of the entities. Kind of a Dubai move as you get an implicit Government backing to with a direct Government equity stake, and still maintain the image of a functioning capitalist system by maintaining the publicly held joint stock entity. Again not a very appealing move for the dollar or US treasuries, but a move that saves some face.

If Fridays market activity is a leading indicator, it would appear that agency debt holders are convinced that the Government will backstop any GSE’s debt, thus turning a deemed implicit backing into an explicit one. At the same time, it appears that equity holders, no matter what decision is finally made, will be left holding very little(if anything at all).

I would like to point out that when I did my piece on the fed’s balance sheet a few months ago, and all the garbage they are supporting; I said that the only thing I was sure of was that treasuries were a sell and gold was a buy. At the time the market was going in the other direction on both of those trades(not tooting my horn but I’ve been a gld holder for a very long time). I am now fully convinced that there is no stopping the gold bull run. It is the easiest trade around, and anyone ignoring it is making a big mistake. The US system has taken a credibility hit that it may never ever recover from or in the best case scenario will take several years to repair. I have concluded that the financial system is full of liars. Whether we are referring to rating agencies, commercial banks, mortgage finance companies, regulators, or investment bank; I no longer believe a word any of them have to say. Foreign holders of our debt will be spending the better part of the next few years diversifying away from the dollar. I expect gold will play a major role in this diversification as central banks and even sovereign funds start to turn from being net sellers to net buyers in the next few years. I know it makes no sense to the rational thinker, but until someone figures out how to print gold it will always appeal to individuals seeking safety and certainty.(and my bet is that group is growing awful fast)

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