Analysing 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 do know about Fannie.
Understanding Fannie Mae
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 US 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 US 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 US regulator, the OFHEO. This has been a license to print money for decades and was the No.1 factor behind the phenomenal return of Fannie Mae stock (NYSE:FNM) 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. The CDS business involves two parties – the sellers and the buyers of default risk.
The buyers shoulder mortgage default risk in return for a future stream of mortgage insurance premiums.
Fannie’s involvement in CDS is compounded by the fact that it also guarantees the value of mortgage-backed securities. The mortgage-backed security (MBS) is the vehicle that has enabled the globalisation and socialisation of US 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 in Yokohama to finance the mortgage of a crane operator in Buffalo…or a teacher in San Diego…an Intel sales executive in Silicon Valley…and thousands of other Americans.
Thus geographical boundaries and prudent lending practices at your local bank are no longer limitations to US mortgage growth. The result has been the hyper growth of the American 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.
Indeed, Europe operates a similar model. The UK mortgage market is also moving into issuing mortgage-backed securities. And you may recall how overexposure to mortgage lending in Texas during the 1980s oil bust was a crucial ingredient in the savings and loan crisis. Hence mortgage-backed securities are seen as a safety net.
But praise of this financial engineering ignores and minimises the self-reinforcing cycle of aggressive lending practices which lead to higher house prices, which lead to more aggressive lending, which leads to even higher house prices.
Human error and moral hazard
Once this beast was unleashed, it took on a life of its own, leading ultimately to the predicament facing central bankers today: House prices must stay elevated, and continue to appreciate at rates higher than the CPI inflation rate, 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 mortgage-backed security market ignore and minimise are human error in the pricing of risk and moral hazard.
Monte Carlo simulation models and supercomputers cannot fully distil 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 ‘globalising’ the mortgage market. The term ‘moral hazard’ originated with the insurance industry, and refers to the incentive of the insured party to increase risky behaviour once it no longer has monetary responsibility for the consequences of risk.
Applied to the mortgage-backed security 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 otherwise they would reject as excessively risky.
US mortgage market: worsening conditions
In effect, institutional and international providers of capital act now as insurance companies that seem unaware of how risky their agents are acting in underwriting US mortgages. A disconnect between those who underwrite mortgages and those who end up holding them 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 securitisation.
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 America’s subprime lending market in a hurry…perhaps outside the US, too…fully pricing in the risks of lending where the collateral is overinflated and many borrowers have been less than truthful about income and assets.
By Dan Amoss for The Daily Reckoning. You can read more from Dan and many others at www.dailyreckoning.co.uk
Dan Amoss, CFA, is managing editor of Strategic Investment, the highly respected US newsletter. Previously Dan worked at Investment Counselors of Maryland – investment advisor for one of America’s top small-cap value mutual funds over the past 15 years.