Market Review: Christmas Turkeys
It’s Christmas. We’re in New York. The feet are elevated, the wine’s fortified and for the first time in 8 weeks, the food hasn’t been fried. And other than the credit rating of Fannie’s preferred stock, keeping warm is the only real concern…
On Friday, Fitch Ratings lowered Fannie’s credit rating by one notch, amid concern that it might not be able to pay dividends next year. And even more troubling, Fitch says they’ll downgrade Fannie’s debt much further should dividends actually become suspended.
Dividend suspension is a very real possibility. Dividends are decided by the Office of Federal Housing Enterprise Oversight (Ofheo) and can only be paid out if Fannie is healthy. But Fannie is not healthy. On Tuesday, Ofheo said the giant mortgage company was ‘significantly undercapitalized’ and ordered it to raise some $3 billion in additional capital by June.
Raising capital can be done in a number of different ways. Fannie can simply issue more preferred stock, or even liquidate some of its mortgage portfolio. This is where credit ratings are important…the better your rating is, the less interest you pay on your debt. So every time they cut Fannie’s rating, her financing costs increase.
This is a big deal, dear reader. But don’t take our word for it…just ask Franklin Raines and his chief financial officer, Timothy Howard. These two book-cookers are now unemployed. Just two days ago, they were at the head of the table, now they’re the main course – a pair Christmas turkeys if you will. Two days ago, they ran the finances of a company with assets over $1.6 trillion. Now they’re at the center of a crisis…a crisis that could easily become the greatest in America’s financial history.
Or ask St. Louis Fed president, William Poole. "It does seem to me," said Poole in a recent speech in Chicago, "that investors have priced these obligations under the assumption that there are no possible risks that might strain GSE capital positions. This is exactly the behavior that has preceded the classic crises described by Kindleberger."
"In my opinion," continues Poole, "GSE capital positions are undesirably thin and leave these firms unnecessarily vulnerable to surprise shocks. There is no way to predict what kind of shock might shake market confidence, but the reason a shock could have serious adverse effects is that GSEs pursue a strategy of borrowing short and lending long with a thin capital margin."
Market confidence remains intact, for now. In fact, this week, the major indexes all hit major multi-year highs. The Dow closed the week at 10,827, a new three-and-a-half year high. The Dow’s highest ever reading was taken in January 2000, at 11,908. In June 2001, it was back above 11,000 again. But it didn’t stay there long…and has never been back since.
Nevertheless, Mr. Market is fighting back, and on the eve of 2005, the Dow’s only down just over 9% from the all-time high. For comparison, the S&P is down 22% and the Nasdaq is down 58%.
The markets maybe showing strength at the moment, but the same can’t be said for everyone. "Since this latest Fannie story broke, the phone’s been ringing off the hook," says Addison Wiggin. "I suddenly find myself inundated with interview requests. Fannie Mae is the only thing these people want to hear about. I’m definitely starting to feel a degree of panic that just wasn’t there before."
Fannie may be crumbling, but it is Christmas. So we shall forget the ‘structural imbalances’ and ‘rating downgrades’…for now! We suggest you do the same. Pour yourself another glass of sherry, dear reader, and have a smashing Christmas,
Addison Wiggin & Tom Dyson
December 25-26, 2004
P.S. This might be late-breaking headline news for the Wall Street Journal and USAToday, but we’ve been all over this story like white on rice. In fact, Eric Fry, editor of the Rude Awakening, wrote, on July 9, 2003, "Fannie Mae, like a great-tasting, non-fat dessert, is simply too good to be true." (You’ll find the complete Fry essay in Flotsam and Jetsam, below).
Since that essay, over a year and half ago, we have yet to let the trail go cold. Dan Denning, editor of Strategic Investment, has been our most vociferous editor. "If I were to tell you of a business – any business – that had racked up over $5.7 trillion in liabilities against $1.2 trillion in assets, you’d be a bit skeptical of their long-term prospects, wouldn’t you?" he asks rhetorically.
"And if I also told you that this total of $5.7 trillion in liabilities was built up during a time period when the borrowers responsible for those liabilities were more likely to default on their obligations than at any point in history…well, you’d certainly avoid buying shares of this company." For more on the implications of a full-fledged Fannie bust…
P.P.S. Addison, by the way, reports initial success in introducing The GRIP…a small cap stock service that targets "jumper" stocks – small caps in overlooked exchanges that are desirable enough to make the leap to Nasdaq, AMEX and other major U.S. stock exchanges.
He’s been working for several months with editor Carl Waynberg and associate publisher James Boric on the
project. They finally pulled it all together this week. And for a limited time only (until January 1st 2005) you can become a charter member of The GRIP for an introductory 80% discount to the future publishing price.
— Book Of the Week —
THE SUBSTANCE OF STYLE
How the Rise of Aesthetic Value Is Remaking Commerce, Culture and Consciousness by Virginia Postrel
*** 50% Discount ***
"The Age of Aesthetics." In this new age, every product, every experience, every place is supposed to offer a touch of aesthetics. In market economies, beauty and style are pervasive, and crucial to the sale. The reason is simple: increasingly wealthy and sophisticated customers demand "an enticing, stimulating, diverse, and beautiful world."
From fashion to cosmetic surgery to restaurant design, the book surveys a wide variety of trends and shows how they fit this common pattern. We hear about Martha Stewart, Starbucks, the iMac, fashion magazines, tiled floors, nice salad bowls, and the Michael Graves brush from Target. The age of Wonder Bread is gone, and the middle class can now buy a sense of style previously reserved for the wealthy.
"Some of the best passages concern globalization," writes an anonymous reviewer. "In Turkey the number of interior design magazines has number from one to forty in a decade. Japan is becoming a fashion capital, while South Korea and Singapore are becoming centers of design."
You can purchase this book at a 50% discount, follow the link…
THIS WEEK in THE DAILY RECKONING
OVER THE TOP
By Bill Bonner
"’But we have had a very good year. We made money; probably more than we deserved. But there is a time and a season for everything. For many, many years we made less than we thought we deserved. Everything tends to balance out in the long run.’"
MYTHS AND MISDEMEANORS
By Carl Waynberg
"Why bother with ROE at all? While ROE can be deceptive, it can also indicate how effective management is at wringing profits out of its operations. Companies that do well at this, tend to have a distinct advantage over their competitors, which tends to translate into superior price performance."
CANARY IN A COALMINE 12/22/04
by John Mauldin
"Hmmm. A strong housing market that might be peaking. A central bank that has been raising rates. A solid economy with inflation starting to pick up. A stock market that looks like it may have peaked? Oh, and did I mention a very large trade deficit? Sound familiar, my fellow countrymen and women?"
THE SPECTRE OF DEFLATION 12/21/04
By John Calverley
"A world of very low inflation, and potentially deflation, makes the current house price bubbles more dangerous than in the past and, from an investor and homeowner point of view, means that houses are a more risky investment. After past price bubbles, house price adjustments were limited in nominal terms by the cushion of high underlying inflation."
DON’T DO US ANY MORE FAVORS 12/20/04
By The Mogambo Guru
"Only a real first-class bozo could possibly believe that the election could not be "fixed," and only a nation as full of morons as the United States would roll over for such a thing without even a whimper. And if the American people are so incredibly naïve and stupid as to allow such a transparent fraud in something as simple as an election, then pulling the wool over their eyes as far as economics is concerned is going to be a breeze!"
FLOTSAM AND JETSAM:
DISROBING FANNIE MAE 07/09/2003
By Eric J. Fry
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 contrat hypothecaires. 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 is forthcoming, but I will happily provide a series of skeptical observations about the widely adored mortgage lender. To preview, my observations cause me neither to like or to 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 that it is difficult fear it. Fannie Mae, like a great- tasting, non-fat dessert, is 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.
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. And what should we think about a mortgage-finance company that produces consistent, non-volatile earnings growth, despite the fact this growth cohabitates with 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 with 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, who has for 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."
Tracy suspects that the era of earnings "smoothing" may be drawing to a close, and if so, the bull market in "managed earnings" is also winding down. Which means that the premium valuations achieved by the masters of the managed earnings – i.e. folks 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 earnings, what it calls ‘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."
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 derivative 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."
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 dollars in consumers’ pockets and that pace has accelerated this year, thereby offsetting a sever 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 one of these two companies would have serious and worrisome implications for their share prices, the housing market, the bond market, the US dollar and the US economy in general. "What a mortal can easily see," says Jim Grant of 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 shareprice.’"