Smoldering Mortgage Market

by Dan Denning

“But housing activity is red-hot,” I’m often told, usually with annoyance, by someone who’s read my ideas about America’s mortgage/housing bubble. Red hot indeed. But so was the hold of the French freighter Grandcamp, which smoldered in the harbor of Texas City on April 16th, 1947.

That accident at Texas City was not the result of a refinery running 24-7, at breakneck capacity, with no time for repairs or for any downtime whatsoever. The Grandcamp was piled high with ammonium nitrate fertilizer. At a little after 9:12 in the morning, after the hold had been sealed and the fireman evacuated, 3,100 tons of ammonium nitrate blew up, raining debris on Texas City, causing a 15 foot tidal wave in the rest of the harbor, and knocking two airplanes out of the sky.

Which brings me to Fannie Mae, Freddie Mac, and derivatives.

You might have heard today’s news that Freddie Mac reported a 42% drop in 2004 profits. Freddie managed to lose $4.5 billion on its derivatives portfolio alone, you know, the one designed to protect the value of Freddie’s mortgage assets when interest rates are volatile. Overall, net income fell from $6.68 per share in 2003 to $3.78 per share last year. Analysts were expecting $6.87 per share.

Why the lofty expectations? Who knows? Freddie hasn’t been current in any of its financial reporting since 2003, when it had to restate earnings by $5 billion after confessing it managing earnings, although, whether that was to smooth earnings out to please Wall Street or to meet executive bonus targets…no court has yet said.

Either way, something is smoldering in the mortgage-lending market, and the heart of fire is on the balance sheets of Freddie Mac (FRE) and Fannie Mae (FNM). Fannie is not without troubles of its’ own. The stock itself is violating a ten-year upward trend and moving toward a serious breakdown.

Will Fannie’s breakdown and Freddie’s earnings crack-up lead to a wider fall in mortgage lending and homebuilding stocks? It wouldn’t be at all surprising.

There are other mortgage lenders, of course. But the big ones are Fannie and Freddie, although they are secondary mortgage lenders, buying up the mortgages issued by the likes of CFC, a primary mortgage lender. These three stocks are all excellent put buying opportunities as the story plays itself out. But don’t forget the homebuilders.

The HGX is made up of twenty-one of the largest homebuilding stocks on the market. It includes the top five: Pulte Homes (PHM), DR Horton (DHI), Lennar (LEN), Centex (CTX), and KB Homes (KB). As an options trader, I’d look at all six stocks, HGX plus the big five, as opportunities for leveraged profit as the bubble bursts.

But if you’re not into leveraged profits, sit back and enjoy the spectacle. Don’t get too comfortable, though. Many institutions – banks, pension funds, even foreign central banks – own GSE-backed bonds. The fire is smoldering.