Figuring Out Fannie

The Daily Reckoning PRESENTS: Fannie Mae, the mortgage-lending giant, is quite the hard nut to crack. And as the conditions surrounding the housing market worsens, a disconnect between those who underwrite mortgages and those who end up holding those mortgages will prove to be a huge problem. Dan Amoss explores…


Analyzing Fannie Mae is like driving without a road map in a foreign country full of unfamiliar traffic rules. The lack of audited financial statements (no road map) and poor understanding of traffic rules (no precedent in financial history) does not give one very much conviction about the value of an equity stake in this behemoth. So let’s start with what we know about Fannie.

Fannie is a “government-sponsored enterprise” (GSE), but it is owned entirely by private stock market investors. The fact that it is “government sponsored” enters the equation if you consider the implied government guarantee backing most of the bonds issued by Fannie. Implied government backing has never been tested in a liquidity crisis – an instance when most expect the federal government would make up any potential shortfall of interest and principal payments to Fannie bondholders.

So Fannie can issue bonds with a microscopic “spread,” or interest rate premium over Treasury bond yields. For example, if 30-year Treasury yields were 6.2%, Fannie could issue an enormous amount of 30-year bonds somewhere around 6.3%. Fannie has a structural competitive advantage over all private financial institutions in the business of providing capital for home mortgages. It is involved in the “carry trade” business, just like most banks, whereby Fannie floats debt at the most competitive rates across the yield curve and invests this borrowed capital in higher-yielding assets, pocketing the “spread” between the rates paid by its assets and the rates paid out to its bondholders.

The “spread” business is fairly straightforward and hinges on how creditworthy the fixed income markets deem Fannie Mae. As long as the 6.3-6.2% spread doesn’t widen dramatically, Fannie can underwrite as many mortgages as the market demands, subject to limitations imposed by its regulator, the OFHEO. This has been a license to print money for decades and was the No. 1 factor behind the phenomenal return of FNM stock during the 1980s and 1990s:

One would expect Fannie executives to be content with this business and not “kill the goose that lays the golden eggs,” but a combination of hubris, greed, and pressure to surpass Wall Street’s rising expectations led to an ill-conceived foray into the “credit-default swap” (CDS) business. Similar to MGIC’s business (see the August issue of SI), the CDS business involves two parties – the sellers and the buyers of default risk. MGIC buys/shoulders mortgage default risk in return for a future stream of mortgage insurance premiums. Fannie’s involvement in CDS parallels MGIC’s role in private mortgage insurance, but Fannie guarantees the value of mortgage-backed securities.

The mortgage-backed security (MBS) is the vehicle that has enabled the globalization and socialization of mortgage supply and default risk. In this default insurance segment of its business, Fannie cobbles together a pool of mortgages that it purchases from mortgage brokers. These mortgages bear similar sizes and risk profiles and are bundled together to form a security that closely mirrors a bond (but includes an expected level of default and “prepayment” risk). This feat of financial engineering enables, for example, a group of Japanese retirees to finance the mortgage of a crane operator in Buffalo, a teacher in San Diego, an Intel sales executive in Silicon Valley, and thousands of others. Geographical boundaries and prudent lending practices at your local bank are no longer limitations to mortgage growth.

The result has been the hyper growth of the mortgage business, bridging the gap between willing lenders and borrowers aspiring to be homeowners. Is this necessarily a bad thing? Not according to Alan Greenspan and the Wall Street establishment. They argue, convincingly, that the diversification of mortgage risk makes global capital markets far more efficient and minimizes the chance of a major bank having “life-threatening” exposure to a depressed regional economy. Recall how overexposure to mortgage lending in Texas during the 1980s oil bust was a crucial ingredient in the savings and loan crisis.

But praise of this financial engineering ignores or minimizes the self-reinforcing cycle of aggressive lending practices leading to higher house prices, which leads to more aggressive lending, which leads to even higher house prices. Once this beast was unleashed, it took on a life of its own, leading ultimately to the predicament facing central bankers: House prices must stay elevated, and continue to appreciate at rates higher than the CPI, to maintain the illusion among the public that an “asset-based” economy is sustainable in the long run.

Two additional factors that the cheerleaders of the MBS market ignore and minimize are human error in the pricing of risk and moral hazard. Monte Carlo simulation models and supercomputers cannot fully distill raw human emotion into neat formulas and pretty bell curves. Misunderstanding the risks involved with financing a home purchase on the other side of the world can lead to an abrupt liquidity crisis when the momentum behind the housing market stalls, as it has now.

Enron was humming along nicely, raising enormous amounts of capital from “efficient markets,” which are commonly elevated to omniscient status, until the company hit a liquidity crunch in which lenders declined to continue financing its giant Ponzi scheme. The important lesson investors should take away from Enron is not how to detect an elaborate accounting fraud, but to expect that greed and fear will overwhelm the “efficient market” theory when the providers of capital underestimate their own capacity for error. Human error and the chances of underpricing default risk should not be underestimated.

The growth of moral hazard is yet another consequence of “globalizing” the mortgage markets. The term “moral hazard” originated with the insurance industry and refers to the incentive of the insured party to increase risky behavior now that it no longer has monetary responsibility for the consequences of risk. Applied to the MBS phenomenon, one can think of mortgage brokers as the insured party. Because they do not retain and service them on their books, they approve mortgage applications that they otherwise would reject as excessively risky.

In effect, institutional and international providers of capital act as insurance companies that seem unaware of how risky their agents are acting in underwriting mortgages. A disconnect between those who underwrite mortgages and those who end up holding those mortgages will prove to be a huge problem. This does not really become obvious until housing market conditions worsen further. Then we will find out the consequences of hyper growth in mortgage securitization.


Dan Amoss, CFA
for The Daily Reckoning
September 12, 2006

P.S. There were probably hundreds of thousands of bad loans written when the sun was shining on this market that will only be exposed once the storm clouds fully gather. This process has only just begun and delinquencies and defaults will cast a pall over the industry. Fixed income investors will flee the subprime lending market in a hurry, fully pricing in the risks of lending where the collateral is overinflated and many borrowers have been less than truthful about income and assets.

Editor’s Note: Dan Amoss, CFA is managing editor for Strategic Investment and a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings to Strategic Investment the unique experience of an institutional background and a drive to seek out the most attractive investments within favored “big picture” trends. He develops investment ideas for SI readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

We are not much given to whistling, even in the dark. But on occasion, we do like to talk about bells. Bell curves, to be precise.

In 20 minutes, we are scheduled to explain our investment theory to a group of Frenchmen and we intend to try out our curved bells for you first, dear reader, before dazzling the frogs.

An example might help. Let us take nature…events in nature. How are they distributed? Well, if you plot the temperature in Paris, with the degrees laid out on the horizontal axis and the frequency (that is, the number of days) piled up on the vertical axis, you will see that they form what statisticians have christened a bell curve. In the middle, where the days that are, say, 60 or 70 degrees are displayed, there will be a lot of them. Out on one end, you will find very few days that are below -20 degrees. And on the other will be very few that are more than 100 degrees Fahrenheit.

Then, if you count the number of days when the average temperature was around 50 degrees, you might find that in a typical year there were 100 days.

So, the odds that any particular day will be 50 degrees are about 100 in 365. And the odds that any particular day is, say, 100 might be only 1 in 365.

Human beings are not calculating machines, but flesh and blood. Their calculations tend to be extremely prejudiced by recent experience. If the last two weeks brought the temperature to 100 degrees every day, they are inclined to rate the odds of another 100-degree day fairly high. And in a sense, they are right. Tomorrows tend to be like todays – especially when it comes to weather, where seasons and climate patterns persist over weeks and months at a stretch.

But human calculations are also affected by many other psychological factors. People want to be accepted by their peers, so they try to bring their own estimates into sync with everyone else. They try not to have opinions that make them seem too “kooky” or “far out.”

And, they fail to look either far enough ahead or far enough behind them to form a realistic view of what the weather is really likely to be. After a long, hot summer, most people anticipate even more of the long, hot days, even though the odds greatly increase that the days will now get cooler in a hurry.

In the investment markets, these misperceptions are amplified by the sticky fact that almost no one has any idea what he is talking about. It is one thing for the lump to register the temperature; it is quite another for him to understand the minutiae of the telecom business…or any other business, for that matter. Instead, he tends to believe whatever the papers are saying.

To make matters much worse for the poor fellow, he has an entire industry – Wall Street – adding to the distortions in his perception, in order to separate him from his money. What Wall Street strategist ever looked the facts clearly in the eye and told his customers what was really going on? Almost none. Wall Street is paid to tell the lumps that stocks always go up in the long run. How then can they form a useful opinion of their own on what is likely to happen to any individual stock? They are bound to overrate the odds that the stock they have in hand really will go up.

All of these factors make the calculations bend like a mountain road. So, instead of believing that the odds of a 100-degree day are 100 in 365, the lump comes to believe the current shibboleth, such as, “it is always this hot,” “housing always goes up,” “hold stocks forever.”

He puts the odds of hot days at 200 in 365.

Here at The Daily Reckoning, we don’t pretend to forecast the weather any more than the stocks. But we can count. And right now, we see a lot of miscalculation among the lumps. And that means a lot of opportunity.

More to come…

First, the news…


Greg Guenthner, reporting from Charm City:

“…Any stock could fall to zero, but many of those speculative picks with the tempting ‘make-it-or-break-it’ stories are the ones that could most likely break not only new 52-week lows, but also your spirit…”

For the rest of this story, see today’s issue of The Sleuth.


And more thoughts…

*** Gold hit the bid yesterday. The price of the metal fell $20, which puts it below our $600 price target.

Will you make money by buying gold now? We don’t know. In fact, we are hardly sure that the near-term trend is up since commodities are falling. And commodities are not alone. Bond yields, too, are falling. Housing is falling. It’s beginning to look a lot like deflation to us. And that will not send gold soaring…yet.

Still, when gold finally does soar, and it will, we will be happy to have bought it at a bargain. The yellow metal may go down, but it won’t go away.

*** Yesterday marked the fifth anniversary of the September 11 attacks. As expected, there was much commentary – looking back on that day, and musings on how the United States has changed since 2001.

One piece that went above and beyond what we were finding in most papers was in yesterday’s TIME magazine, called “The Nation That Fell to Earth.”

The author of this article is one of the world’s leading historians (and DR reader) Niall Ferguson. He writes as though it were the year 2031 – so we’ve really had some time to reflect on how well America responded to the events of that day – after all, hindsight is always 20/20. If you haven’t had a chance to read it, we’ve picked out some of the highlights for you:

“…the war that began on Sept. 11, 2001, was democratic in a strategic sense, since the democratization of the greater Middle East became one of America’s principal war aims. It was an aim inspired by the democratic-peace theory, which stated that democracies were less likely to go to war with one another than were other kinds of states and that therefore a world with more democracies would be a more peaceful world. That became President George W. Bush’s central argument for the post-9/11 invasions of Afghanistan and Iraq. Bush summed up the strategy in his second Inaugural Address, in 2005: ‘The best hope for peace in our world is the expansion of freedom in all the world.'”

However, instead of making the “world safe for democracy” like any good world-improver would aim to, “by the time of the fifth anniversary, many experts argued that the U.S. reaction to 9/11 had failed to eliminate the terrorist threat and instead had made the world a more dangerous place. Bush’s defenders, meanwhile, insisted that the President’s strategy was still the one that would ultimately win the war on terrorism. Only history could determine which side would be proved right.”

More from Mr. Ferguson to come tomorrow…

*** This morning, we walked in front of the Crillon hotel, where rock stars and politicians stay. It is also where Earnest Hemingway claimed to have “liberated” the bar when the Germans abandoned the city.

Out front of the hotel was a line of black cars, the kind used to chauffeur VIPs around town, and a group of bodyguards gathered together talking to each other.

We had, until then, not given a thought to killing anyone. But when we looked at the shifty-eyed bodyguard, studying us as we went by, we began to wonder about it. How easy it would be, if we really wanted to! We feel the same sense of challenge when we see a protective wall. Or a locked liquor store. Instinctively, we look for a way to break in.

The guard kept his eye on us the whole time we passed, looking away whenever we caught his glance. He probably wondered what was in our brief case. His job is to wonder and make sure no one offs his boss. Fortunately for him, there are probably not really many men bent on homicide this morning…or any other.

Which makes us wonder more and more about the great British bomb plot. What really was going on?

The question seems to have occurred to Craig Murray, former British ambassador to the gentle republic of Uzbekistan, which has acquired an unpleasant reputation for boiling suspects in vats of boiling liquid. Either water or oil, we are not quite sure which. Murray brings his close acquaintance with the fine arts of coercion to bear on the subject:

“None of the alleged terrorists had made a bomb. None had bought a plane ticket. Many did not even have passports, which given the efficiency of the U.K. Passport Agency would mean they couldn’t be a plane bomber for quite some time.

“In the absence of bombs and airline tickets, and in many cases passports, it could be pretty difficult to convince a jury beyond reasonable doubt that individuals intended to go through with suicide bombings, whatever rash stuff they may have bragged in Internet chat rooms.

“What is more, many of those arrested had been under surveillance for over a year – like thousands of other British Muslims. And not just Muslims. Like me. Nothing from that surveillance had indicated the need for early arrests.

“Then an interrogation in Pakistan revealed the details of this amazing plot to blow up multiple planes – which, rather extraordinarily, had not turned up in a year of surveillance. Of course, the interrogators of the Pakistani dictator have their ways of making people sing like canaries. As I witnessed in Uzbekistan, you can get the most extraordinary information this way. Trouble is it always tends to give the interrogators all they might want, and more, in a desperate effort to stop or avert torture. What it doesn’t give is the truth.

“The gentleman being ‘interrogated’ had fled the U.K. after being wanted for questioning over the murder of his uncle some years ago. That might be felt to cast some doubt on his reliability…

“We then have the extraordinary question of Bush and Blair discussing the possible arrests over the weekend. Why? I think the answer to that is plain. Both in desperate domestic political trouble, they longed for ‘Another 9/11.’ The intelligence from Pakistan, however dodgy, gave them a new 9/11 they could sell to the media. The media has bought, wholesale, all the rubbish they have been shoveled.

“We then have the appalling political propaganda of John Reid, Home Secretary, making a speech warning us all of the dreadful evil threatening us and complaining that ‘Some people don’t get’ the need to abandon all our traditional liberties. He then went on, according to his own propaganda machine, to stay up all night and minutely direct the arrests. There could be no clearer evidence that our Police are now just a political tool. Like all the best nasty regimes, the knock on the door came in the middle of the night, at 2.30am. Those arrested included a mother with a six-week-old baby.

“We will now never know if any of those arrested would have gone on to make a bomb or buy a plane ticket.

“In all of this, the one thing of which I am certain is that the timing is deeply political. This is more propaganda than plot. Of the over one thousand British Muslims arrested under anti-terrorist legislation, only twelve per cent are ever charged with anything. That is simply harassment of Muslims on an appalling scale. Of those charged, 80% are acquitted. Most of the very few – just over two per cent of arrests – who are convicted, are not convicted of anything to do terrorism, but of some minor offense the Police happened upon while trawling through the wreck of the lives they had shattered.

“Be skeptical. Be very, very skeptical.”

And actually, that is also probably some of the best financial advice you’re ever likely to get.

The Daily Reckoning