Fannie and Freddie Are Surely Doomed

“The downturn in the housing market is beginning to bite corporate Australia,” reports Ben Butler in today’s Herald Sun. “Shares of big building supplies company CSR plunged almost 15 per cent yesterday after it warned the housing market was taking a hit from high interest rates and declining confidence.” And so it begins.

Actually, it began years ago when people began to think that house prices always go up in double digits. But anyway, it will be interesting to see how things develop in Australia. In the U.S. and the U.K. the mortgage lenders fells first, then the builders, then the banks, and finally the consumers.

The two big pillars of the U.S. mortgage system—Fannie and Freddie—are surely doomed now. First, U.S. Fed Chairman Ben Bernanke told Congress both are well capitalized. Haven’t we heard this one before?

Isn’t this what Bear Stearns said before it collapsed? Didn’t Citigroup say it was well capitalised, and then ask for more money? Why would anyone believe these investment bankers anymore when they tell the public they are well capitalised? It’s almost like the moment a CEO of a company says it’s “well capitalised” you should be prepared for a nasty shock.

We don’t mean to alarmist about the GSEs. But as we explained to a colleague over the weekend, our job here at the Old Hat Factory is not to tell you what you may already know, or can read in the papers. Our job is to tell you about the low-probability but high magnitude investment events that could affect your money. And just to be clear, the collapse of Bear Stearns and the whole credit crisis would look like mere child’s play should a genuine crisis unfold in the quality of the debt owned and guaranteed by Fannie Mae and Freddie Mac.

It would be the equivalent of that absurd scenario in that global warming movie a few years ago, where the Gulf Stream stops flowing and the entire Northern hemisphere enters a new ice age...in a matter of days. The insolvency of the GSEs is as close as you’re ever going to want to get to Financial Doomsday and live to tell about it.

Yet just yesterday Former Fed Governor William Poole told the world what many have been saying for awhile now: if you use conventional accounting methods, Fannie and Freddie are already technically insolvent.  Poole said, “Congress ought to recognize that these firms are insolvent, that it is allowing these firms to continue to exist as bastions of privilege, financed by the taxpayer”.

In simple terms, Poole points out that Freddie Mac owes US$5.2 billion more than its assets are currently worth. Shareholders took note.  Fannie shares fell 14% in New York trading while sister Freddie fell 22%.

What’s really bad news for these companies is that two U.S. Senators stood up to tell the world that these two companies are “too big to fail.” Republican Presidential nominee John McCain told reporters, “They must not fail,” and that they “are vital to Americans' ability to own their own homes.”

Later, the distinguished windbag Senator from the state of New York, Charles Schumer said, “Markets should be assured that the federal government will stand by Fannie Mae and Freddie Mac.” He said the firms are “are too important to go under,” and Congress “will act quickly”.

Who do these men think they are, Moses parting the Red Sea. We’ve never seen public servant or elected politician perform a miracle. Acts of God that defy the laws of nature are generally reserved to...you know...God.  Saying something “must not fail” doesn’t mean you can prevent it.

But it’s Friday. So how about a hand for the unbridled idiocy of American policy makers! How about a standing ovation for the dizzying heights of audacity reached by people so far out of touch with reality that they believe they can defy the laws of economics? Hip hip! Hooray!

What exactly do you think the U.S. Congress can do to save the GSEs? By our reckoning, it can provide the GSEs with cash to continue to meet operating expenses. There are only two other options. And let’s be clear about this: if the U.S. Government chooses either of the remaining options, it will be a virtual death blow for the U.S. dollar the rest of this year and pop the largest remaining sub-bubble in the credit market.

What can Congress do? First, it can ask the Fed to extend its securities lending program to the GSEs. Fannie and Freddie would be able to exchange impaired mortgage-backed bonds for liquid U.S. Treasuries. Granted, the Fed is running low on Treasuries already, having lent billions to its buddies on Wall Street. But that is a great thing about being a central bank with a monopoly on money. The Fed can simply print more money to buy more Treasuries (although the U.S. Treasury Department would have to create new debt to sell to the Fed).

The other option for U.S. policy makers is to clearly state that Fannie and Freddie bonds are backed by the full faith and credit of the United States government. You can take that for what it’s worth. We wonder how the bond market would take it. How much faith and credit does the world currently have in the financial position of the United States?

Fannie and Freddie have guaranteed more than US$5.2 trillion in mortgage-backed bonds and securitised mortgages. Who owns them? As we said the other day...everyone! Central banks...pension funds...insurance companies. The big and terrifying fact for the world’s financial system is that GSE debt makes up some portion of the assets of many financial institutions and investment funds.

The U.S. government can move to stabilise that market by guaranteeing the debt. But we believe that if it does so, it will lead directly to the popping of the other big remaining bubble in the credit markets: the U.S. Treasury market (bonds and notes).

In the sixty three years since the end of World War Two, there hasn’t been a much safer investment on the planet than U.S. Treasury bonds, at least according to conventional wisdom. But the credit rating agencies, for what they’re worth, would have to take a serious look at downgrading the credit quality of sovereign American debt if the U.S. government changed its implied backing of GSE debt to an explicit backing.

The consequences of a (much deserved) lower credit rating for the U.S. government are too long to go into here. Suffice it to say the bond market won’t wait. The trouble is, what do you do with your money if government bonds aren’t safe? Cash is one answer. Owning some form of your wealth in precious metals is another. Gold should regain ground against oil in the second half if the GSE story continues to unfold in nightmare fashion.

In any event, it hasn’t quite come to that. Congress, Obama, and McCain must all be hoping that the GSE problem just goes away, at least until after the election. But the market will not wait. It could be a brutal summer.

As the GSE story unfolds, we may have to revise our oil forecast. All things being equal, there are plenty of signs that high oil prices are hammering economic activity. That should lead to lower oil prices. But the GSE problem is going to weaken the dollar one way or the other. A weaker dollar means higher oil prices, regardless of what happens in the global economy...or Iran. And on that score, the oil price moved up US$5 as the Iranians lobbed a couple of missiles into the sky.

Speaking of oil, CSIRO released a new report today wondering where Australia would get its future liquid fuels in a world of higher energy prices. CSIRO’s  Dr John Wright says, that,  “Australia’s fuel mix will shift in the near term to include the expanded use of diesel, gaseous fuels such as LPG and hybrid electric vehicles, with even greater diversity beyond 2020 that might include hydrogen, synthetic fuels from coal or gas and advanced biofuels that will not impact food production.”

The report also went out of its way to define Peak Oil. “Peak oil,” it tells us, “is the point in time when oil production reaches its maximum annual rate, after which the annual production declines each year. While the term is currently used to describe a peak in total world oil production, in practice, a succession of peaks have already occurred in different oil-producing regions throughout the world.”

But wait, there’s more. “Eventually the rate of production decline at mature oil fields exceeds the rate of expansion at new oil fields and total world production will have peaked.”

Pretty simply put, and hard to argue with. The report then predicts that in a worst case scenario, petrol could cost you...$8/litre. Hey, we didn’t make it up. The chart is below.

Petrol to reach $8/litre?

Source:  Fuel for Thought, the Future of Transport Fuels, Challenges and Opportunities, CSIRO, June 2008

That $8/litre figure comes from a scenario in which oil production declines faster than expected and alternative fuels don’t develop more quickly. As we’ve highlighted here and in our small cap letter, the race to find substitutes for petroleum is well and truly on. There will be many losers and a few winners.

According to CSIRO speculation, ethanol will play a much bigger role in Australia’s fuel mix, along with fuel cells, coal-to-liquids, and plug-in-hybrids. We’ve got exposure to each of these potentially vast markets with our share tip recommendations in the small cap letter. It’s going to take a portfolio of energy experiments to get the world over the Peak Oil hump—and that’s if we get over the hump.

CSIRO’s Future Fuels Portfolio

One small housekeeping note. A few readers of Diggers and Drillers have written in wondering why they have to subscribe to a whole new newsletter to get the share tips from the small cap market. A fair question, with what we hope is a useful answer: they are written by different editors with different investment ideas.

Diggers and Drillers is a resource newsletter written by Al Robinson, an Australian with a background in finance and a specialist at analysing resource stocks. Al has his own ideas, his own world-view, and his own research on Aussie resource stocks.

The small cap letter may pick resource stocks from time-to-time (if we think that have a huge resource that’s trading at below market value and something will change that in the near future). But most of our small-cap tips are in energy, technology, biopharma, and other industries that have nothing to do with resource economics. These companies have new businesses in new industries, and often, for the firm to work, the industry has to develop commercially.

It’s exciting stuff. But it’s vastly different from the resource industry. So they are different letters written by different men with different investment approaches. Ultimately, they are both judged by how well the tips perform. Ultimately, both are directly related to the global boom in urbanisation and soaring energy prices, but invest in it from different direction. And yes, if you’re interested in both, we’re going to make it possible for you to get them both for one price. Stay tuned.

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