Disrobing Fannie Mae
Last week, a French reader of the Daily Reckoning inquired, “Bonsoir, J’aimerais bien connaître l’opinion de M. Eric Fry en ce qui concerne Freddie Mac et Fannie Mae, les grandes firmes americaines de refinancement hypothecaire. Merci.”
Translation: I’d like to know Eric Fry’s opinion about Freddie Mac and Fannie Mae, the large American mortgage companies.
I was flattered that a Daily Reckoning reader – and one who is neither a relative nor a close friend – would solicit my opinion. But I will demur. No opinion will be forthcoming. However, I will happily provide a series of skeptical observations about Fannie, the widely adored mortgage lender. To preview: My observations cause me neither to like nor dislike the company’s stock, merely to fear it.
It is not easy to become rabidly negative about a stock selling for nine times earnings. But that does not mean it is difficult to fear it. Fannie Mae is like a great- tasting, non-fat dessert, simply too good to be true. Beginning with its privileged status as a government- sponsored enterprise (GSE) and ending with its impossibly consistent earnings history, there is almost nothing about this financial behemoth that is NOT too good to be true. The company is a financial marvel.
Fannie Mae: Magic or Brilliant Management?
When a mortgage-lending institution grows its earnings year after year at a rate that is several times faster than GDP growth, something is too good to be true…especially when that spectacular growth rate coincides with an equally spectacular increase in debt and balance-sheet leverage. What should we think about a mortgage-finance company that produces consistent, non-volatile earnings growth, alongside an imposing Kilauea of volatile interest-rate derivatives rising up from its balance sheet (or from some location perilously close to its balance sheet)?
And yet, somehow, this behemoth produces perfectly smooth, consistent earnings growth year after year. How does this happen? Is it magic? Or just brilliant management?
Investors must believe it is the latter, or they would not have awarded Fannie Mae a premium valuation relative to other mortgage lenders and financial institutions. Fannie’s stock sells for nearly four times book value. Citibank and Bank of America, by comparison, both trade for about two and a half times book value.
“Fannie and Freddie both engage in some form of ‘earnings smoothing,'” says Apogee Research’s lead analyst, Robert Tracy. Tracy has been digging deep into the financials of Fannie Mae and a couple of other well-known GSEs. “Naturally, senior officers at these companies eagerly justify their unusual accounting practice as something more ‘accurate’ and ‘helpful to investors’ than conventional GAAP accounting. But that assertion is highly debatable,” says Tracy. “One thing is certain, however – their cosmetically enhanced earnings have been helping to boost their share prices and valuations. And a higher valuation means much larger paydays for the heavily optioned management.”
Fannie Mae: Premium Valuations Fading Away
Tracy suspects that the era of earnings ‘smoothing’ may be drawing to a close. If so, the bull market in ‘managed earnings’ is also winding down. Which means that the premium valuations achieved by the masters of managed earnings – i.e., entities like Fannie Mae – will fade away.
“By its very nature, the mortgage finance business, which extensively uses derivatives to hedge various forms of interest-rate risk, will experience erratic trends in GAAP earnings,” Tracy continues. “To smooth out the reporting of those GAAP trends, both Freddie and Fannie turned to pro forma disclosure, a method whereby Fannie designated its pro forma numbers as ‘core business earnings’ and Freddie used the term ‘operating earnings.’ They encouraged the investment community to focus not upon their GAAP earnings, but rather on pro forma disclosures that excluded certain items, most notably the impact of changes in the valuation of derivatives.
“Over at Fannie Mae headquarters, management continues to cling to its preferred version of ‘core business earnings.’ I guess you can’t blame ’em for trying to put the best spin on things – so long as they can get away with it. Fannie’s pro forma treatment dishes up a more pleasing and consistent earnings trend than the erratic swings you get with GAAP. Then, too, for the past six quarters, Fannie’s reported GAAP earnings totaled $8.5 billion, while pro forma net income totaled $9.7 billion. Who wouldn’t want to claim an extra $1.2 billion of earnings? You have to admit that, from Fannie’s perspective, pro forma is a win-win situation: not only do the earnings appear more consistent, but, all of a sudden, there’s $1.2 billion more of them!”
“So is all the bad news out on the GSEs?” I asked the Apogee analyst. “After all, Freddie Mac’s own chairman, Shaun F. O’Malley, declared on June 25: ‘The company remains safe and sound.'”
“I don’t believe him,” Tracy replied. “I don’t think he’s lying. But he may be mistaken. Investors still do not have access to enough detail about the company’s finances to be able to invest confidently in its shares.”
Fannie Mae: Ignorance Is Not Bliss
In other words, in the case of the GSEs, ignorance is not bliss.
“What, for instance, would have happened had Freddie bet the wrong way on interest-rate movements,” Business Week asks provocatively, “or if banks, fearing further problems, refused to buy its debt? Freddie’s problems reveal just how little is known about its inner workings – and highlight the risks should the markets lose confidence in its ability to manage its huge derivatives portfolio.”
If these companies weren’t so big, we might not care how they account for the thousands of derivatives contracts on their books. But Freddie and Fannie are not merely part of the housing market, they are the housing market.
“Fannie and Freddie now carry an astronomical $1.6 trillion in assets on their balance sheets, up from $962 billion in 1999,” Business Week notes. What’s more, based on the Fed’s recent flow-of-funds report, a whopping 77% of total U.S. financial-sector debt outstanding as of the end of this year’s first quarter resided with the GSEs, federally regulated mortgage pools and the asset-backed issuers.
“These are the very folks at the direct heart of, and largely responsible for, the bulk of current credit creation in our economic system,” observes Contrary Investor. “Many of these financial-sector participants are also significantly leveraged to derivatives as part of the risk-management component of their credit-creation operations. And these folks are operating completely outside of the regulated U.S. banking system.”
Fannie Mae: Singlehandedly Pulling Down the Economy?
Not surprisingly, these two lending giants also wield a giant-sized influence over the U.S. economy. Last year, refinancing activity put an extra $100 billion in consumers’ pockets, and that pace has accelerated this year, thereby offsetting a severe drought in capital spending. If these two companies can almost single-handedly support the economy, couldn’t they single-handedly pull it down?
Is it an exaggeration to infer that a serious problem at either of these two companies would have serious and worrisome implications for their share prices, the housing market, the bond market, the U.S. dollar and the U.S. economy in general? “What a mortal can easily see,” says Jim Grant, writing in Grant’s Interest Rate Observer, “is that a Freddie accident would be a dollar accident as well as a corporate-finance accident.” In other words, containing financial market volatility is a little bit like herding cats. Who can say what sorts of traumas may result from the brave new world of volatility at Fannie Mae and Freddie Mac? Lower share prices would seem to be the best- case scenario.
“I’m hoping for the best,” says Tracy, “but I fear the worst. Now that two prominent members of the GSE family have come under the harsh light of disclosure, it’s only a matter of time before their share prices reflect the real- world volatility and uncertainty of their earnings results. ‘Uncertainty’ is just another way of saying, ‘falling share price.'”
The Daily Reckoning
July 9, 2003
Tech stocks led the charge of the light-headed brigade again yesterday. Internets, for example, went 1.8% deeper into the Valley of Death, as Ebay approached its all-time high.
They are not likely to get out alive, is our guess.
All great bear markets are accompanied by great bear market rallies. This one won’t be any different. Which is not to say the rally can’t go on for a long time and make a lot of people think they are getting rich.
But that is the idea, after all – that’s what makes it a great bear market; it takes a great many investors down with it.
Eric is still at the beach. Addison is on his way to the hospital again this morning, following yesterday’s false alarm. They have left your editor alone at the helm of the Daily Reckoning. Is that a sand bank he sees? Or is it a fog bank? Or a Federal Reserve bank? Damn the torpedoes…full speed ahead!
And so we push on…dear reader…into the Great Unknown…
And who is that hiding in the bushes? Why, it’s Mr. Bear! Of course, can’t come out and scare everyone right away. He’s got to let them think it is safe…that there is nothing to worry about. So, he mauls a few investors and then retreats. The others think he’s gone away for good.
“It’s okay…,” they tell each other. “The long-term bull market is still in business. Don’t be wimps…c’mon, let’s have fun…”
That ‘good time’ attitude can take a lot of wear and tear before it finally gives way. We are 40 months into the Great Bear Market, and still investors believe in the eternal bull market on Wall Street. They shifted from stocks to bonds…and now seem to be shifting back to stocks (who wants to miss the next bull market!). But the belief in The System – in Wall Street…in American capitalism…in the Federal Reserve and the dollar…in the democratic government…in Social Security…unemployment compensation…in mortgage refinancing…and in all the institutions of the great social welfare state of the late Dollar Standard period – remains intact.
How can it be, we ask ourselves? How can people still be not only believers, but True Believers, with more faith in the American System than Russian Marxists ever had in communism?
One answer is simple. While we are 40 months into the correction, the boom that preceded it developed over the course of an entire generation and shaped its habits. The Dollar Standard came into being when Richard Nixon eliminated gold from the international monetary system in the early ’70s. Henceforth, central banks would measure their reserves in dollars, not in gold. And henceforth, Americans were able to print as many dollars as they wanted, without worrying about whether they had the gold to back them up.
There is probably no one more spendthrift than the man who can print money in his own garage. By Year 15 of the Dollar Standard period, Americans had spent so much that the nation slipped below the water line of debt, having been the world’s largest creditor a few years before. By year 30, it had sunk so deep it was the world’s largest debtor…and the largest debtor the world had ever seen.
Yesterday’s news brought word that the U.S. had achieved yet another record. Its trade with China produced the largest deficit between two countries the world has ever seen. Walmart alone bought so much stuff from China that it would be China’s 8th largest trading partner, ahead of Britain and Russia, if it were a sovereign nation. And the gap continues to widen!
Automotive News: “The shift to Chinese production eventually will cost hundreds of thousands of manufacturing jobs in the United States. And it will put more pressure on smaller, cash-strapped suppliers to make a risky investment on a distant continent.
“Both Ford and GM are offering a two-continent deal. If a supplier builds a factory in China, it can sell parts to a Ford or GM assembly plant in China, then export parts to the automaker’s North American assembly plants. Those deals are starting to add up. According to the U.S. Department of Commerce, total imports of Chinese auto components totaled $2.2 billion last year, nearly triple the volume of imports in 1997.
“China will dwarf the impact Mexico has had on the U.S. auto industry,” says Detroit economist David Littmann. From the perspective of North America’s purchasing managers, Littmann says, “China is vastly more encouraging than Mexico.
“For automakers, China looks like a bargain. For suppliers, that price can be steep. In the years to come, segments of the U.S. supplier industry may migrate to Asia. For example, U.S. mold and die makers already have lost an estimated 6,000 jobs to Chinese rivals in recent years.”
Russian communists were undone by the very materialism they adored. Everywhere they looked, outside their own country, people were getting rich from market-based economies. Their socialist system could not keep up. So, they abandoned the race altogether.
Now, it is our turn. The True Believers seem not to notice, but socialism took root in America as well as Russia. Retirements were socialized by the Social Security program. Unemployment compensation, EEOC, OSHA, and welfare programs socialize the job market. Wealth itself is socialized by means of a progressive income tax and various redistribution programs. There is little left in American life that isn’t socialized, regulated, controlled, bullied, or menaced in some way by government. Freedom in the modern homeland is, as the songwriter puts it, “ah…that’s just some people talking.”
Why would Americans put up with it? Why would they give up their freedom without a fight…and now support The System more than ever before…in the name of “liberty?”
We came across this passage in a book by Gerard Maudrux:
“Bismarck created the first general welfare system in 1889. Why? Out of a sense of charity, philanthropy or civic spirit? No. This brilliant and ambitious politician had found a good way to make the subjects of his empire docile. His reasoning was simple: when the citizens all depend on the state, they won’t try to overthrow it or destabilize it, and they will easily give up their fundamental liberties. The State will then become stable and eternal…as long as the system doesn’t fail, which is why you have to maintain it at all costs.”
But now, globalized markets are making it hard for socialized America to compete. The system struggles forward, but cannot seem to make much headway. Hundreds of billions of new dollars are printed, but the U.S. economy barely grows. Interest rates are cut 13 times, and jobs at home are still lost. Meanwhile, the Chinese…with neither the shackles of tort lawyers or Medicare, nor the ball and chain of debt or neo-cons…can produce almost anything we can – but faster, and cheaper.
And Mr. Bear hides in the bushes.
*** The price of gold fell another $4 an ounce. Strange. In a world in which inflation is supposedly on the increase, the main benchmark of it is falling. But if all the contradictions were removed from today’s financial world – there would be nothing left.
*** Yesterday, at lunch, your editor had an unexpected pleasure. A young woman came and sat down in his lap.
“Hey, big spender,” she began to sing, suggestively wiggling around.
Later, after the performance was over, she passed the hat, into which your big-spending editor tossed a euro coin.
“Is this a profitable line of work?” he wanted to know.
“It’s a living,” came the answer.