In It Together

As most of the market has gone down – two very curious stocks have gone up. Fannie Mae shares rose more than $3 on Monday to close at $87.81. Both Fannie and her brother Freddie Mac are at near record highs. Indeed, Fannie Mae shareholders have realized a 41% gain for the year. Freddie Macs owners have done even better – with a 45% boost.

The burden of today’s letter – to come right to the point – is that these two companies give us a glimpse into the future, and it isn’t very pretty.

The two companies are GSE’s – Government Sponsored Enterprises. They are neither fish nor fowl – neither creatures of the free-market, nor purely bureaucratic agencies…but monsters, half market, half politics (half man, half beast you might say) whose effect on the nation’s economic future may be, well, monstrous.

“Fears of a U.S. credit squeeze have been growing,” observes the Financial Times, “amid mounting evidence that corporations borrowed too much during the recent boom and will have trouble paying back their debts.”

Credit used to be controlled by bankers. The banks would suffer through the credit cycle – alternately lending too freely and then too miserly – and take their losses according to their merits. Occasionally, following a period of especially reckless lending, banks would go bust along with their customers.

But something has changed. Now, “loans are mutating into another form of tradeable paper,” says the FT, “as fit for a mutual fund or an insurer…”

Or a GSE!

Bloomberg reports that “Banks are selling mortgages, possibly their safest assets, because their corporate loans are going bad and aren’t marketable.” Banks need the money – and they can sell their mortgages – to Fannie and Freddie.

Freddie Mac buys these bank-generated mortgages in bulk – and is increasing its purchases at a 50% annualized rate. Altogether, Freddie and Fannie – chartered by the federal government to make mortgage money available to people who couldn’t otherwise quality – now own 40% of the entire $5.5 trillion U.S. mortgage market.

Those are the facts. They are readily available and, I suppose, true. But the valuable truth is the one that is harder to see: what do these facts mean?

“When Standard & Poor’s measured exposure to the troubled telecoms sector at leading global banks,” continues the FT article, “it found that none of them had anything near a dangerous level of risk. A decade ago, a big bank might have made commercial real estate loans equal to 80-100 per cent of its tangible equity. Using information not available to the public, S&P calculated that most leading lenders have limited their telecoms exposure to about 8 per cent of tangible equity.”

Telecom debt, S&P concluded, had been `atomised’ – spread across the global financial system. The same might be said of mortgage debt. A local banker would succeed or fail, get rich or go broke, on the strength of his personal judgment. If he misjudged a credit risk, the loan would go bad and he would suffer the consequences.

But now the loans are `atomised’ – sold off to the largest holders of mortgages in the world…carrying, between them, debt paper equal to 20% of the nation’s entire GDP.

If a mortgage goes bad, the banker who made the loan will not be the one who suffers. Instead, the suffering will be widespread. The risk, in other words, has been collectivized. It has been removed from the shoulders of the person responsible for it…and placed on those of thousands, or millions, of equity holders.

It may eventually fall on taxpayers too – when the GSEs’ reckless lending finally catches up to them..

The risk is no longer that a bank or two will go belly up…but that the whole financial system will go belly up. More to come…

Bill Bonner Baltimore, Maryland December 20, 2000

P.S. One of the more interesting debates among intellectuals concerns the effects of the new information technology on ideas. Most people expect the Internet, for example, to allow thousands of flowers to bloom. Mass communications and mass ideas are supposed to give way to millions of independent ones.

This is consistent with the notion of Darwinian specialization. Ideas, like life forms and businesses, are supposed to evolve and become ever more differentiated, specialized and sophisticated.

And yet, what we have seen is that increases in the division of labor and knowledge seem to lead to collectivized stupidity. Unable to form an opinion on the quality of the meat they eat…nor on the quality of mortgage debt bought by Fannie Mae… they turn to the mass-marketed and most widely distributed ideas available.

Ideas, it turns out, are not immune to Metcalfe’s Law. They more widely they are taken up, the more value they give to each holder. The more people who believed that the stock market was going up, for example, the more it went up. And the more people who agree with what you believe – the more you are inclined to believe you must be right!

Uniformity, however, comes at a price. Vulnerability. When everyone is in the same boat, a single leak can sink them all.

More on this too…as I get it figured out.

*** Alan spoke! The markets choked. And everybody’s going broke.

*** “Take a look at this,” said Beth calling me over to see the Nasdaq chart yesterday afternoon. “There goes my retirement.”

*** The chart looked awful. After rising in anticipation of Greenspan’s speech…then hesitating as investors tried to figure out what it meant…the line just seemed to fall away.

*** The damage was no worse than on a lot of other days, but the disappointment was greater. Investors still believe they are protected by the Greenspan Put…but the Fed chairman refused to use it yesterday. Instead, he merely announced a change of bias – from fighting inflation to fighting recession.

*** The Nasdaq ended the day down 113 points. The Dow slipped 61 points. Advances and declines were about even…and there were twice as many stocks hitting new highs on the NYSE as new lows.

*** Microsoft and Cisco both fell – and both to $44 and change. Cisco is the only big tech that has not yet admitted any weakness. It has never issued a profit warning and never failed to meet or beat its earnings and sales targets. Cisco remains the world’s second most valuable corporation – with a market cap of $300 billion. But the stock price is falling anyway – and will probably go down much more before it comes to rest.

*** Amazon fell too – along with almost all the dot.coms. AMZN closed at $18. Will the company survive? The index fell 8% yesterday.

*** “I let myself down,” humbly confessed WorldCom CEO, Bernie Ebbers, recently. WorldCom’s market cap was $150 billion a year ago. Now it’s about $50 billion.

*** “Even in the twilight world of zombies,” opined the Economist, “it is hard to find many who have gone from hero to zero quite as spectacularly as Mr. Ebbers.”

*** And here’s something interesting – the XAU, the index of gold mining stocks, rose 3%. Investors are getting worried. Not so much about inflation…but about solvency…the quality of debt…and the integrity of the financial system, generally. Gold may become more popular as those fears increase.

*** “‘Today my 16-year-old niece explained the wondrous concept of compounding and the time-valued money to me’,” William Fleckenstein wrote on January 19th, 2000, quoting a reader who’d written in illustrating life at the height of the bubble. “According to my niece,” his correspondent continued, “her teacher assumed, that by investing in `technology stocks,’ that a `reasonable rate of return’ for the foreseeable future should be on the order of 50 percent annually.” Those were the days, huh? (program note: In an attempt to send 2000 off in style, The Daily Reckoning will be featuring “Air Ball: Revisiting The Bubble Blow-off” – Bill Fleckenstein’s 9-part series plumbing the depths of this year’s stock market mania.

*** Margin accounts peaked out in March at $278 billion. They’re down to $219 billion now.

*** And even the trade deficit may have peaked out in September at $33.7 billion. October’s number was $33.2 billion. If the dollar collapses, as expected, the trade deficit will fall too.

*** The dollar gave up a little more ground to the euro yesterday. The euro, thought to be hopeless a month ago, has risen nicely since then.

*** Oil fell 63 cents yesterday.

*** Asia is a mess. The Tokyo stock market is only a few points above its record low of 1998 – more than 60% below its high of 1989! Korea’s biggest companies are on the verge of bankruptcy – or already `in chapter’. And Taiwan no longer publishes consumer confidence numbers – they’re thought to be too depressing.

*** The whole region suffers from the effects of monumental debt, overcapacity, and bad investments. Could America be hit with similar problems? Nah…don’t worry about it.

*** The Industry Standard reports on what it calls “gadget fatigue.” Sales of consumer electronics are slumping. A trade association notes that more new products will enter the market between ’98 and 2003 than in the entire history of the industry. Who can keep up with all this stuff?

*** Sales of Winnebagos have fallen 23% during the most recent quarter, compared to a year ago. Profits are off 18%.

*** Bianco Research says investors expect a quarter point drop by the Fed in the first quarter of next year. But so far, investors – and the Fed – have underestimated the intensity and speed of the current slowdown. More than likely, the Fed will act sooner…and more vigorously than expected. That will be surprise number one. Surprise number two? It won’t work.

*** “The very quality that makes the stock market such a good place to invest, most of the time,” repeating my quotation from Smithers and Wright’s “Valuing Wall Street,” “means that it has to be a lousy place occasionally. One of those occasions is now.” A quarter point won’t make much difference. Japan took its rates down to zero – and even that didn’t make much difference.

*** Mt. Vernon Square is coated in white this morning. The snow has covered the patches of hard-beaten earth, and cigarette butts… The Winter of Woe begins tomorrow.

The Daily Reckoning