The Two Pillars of the U.S. Mortgage Market, Fannie Mae and Freddie Mac, Wobbled Again Yesterday

"Thousands give up on home ownership dream," reports Eli Greenblat in today's Age. The Australian Bureau of Statistics reported yesterday that the number of new home loans for owner occupied housing fell by nearly 8% in May, and by 25% in the last four months. Builders aren't building, even though immigrants are still coming to Australia in droves.

All of this has Craig James, the lead economist at ComSec, perplexed. "Something has to give unless you are going to have people in their 30s and 40s still living at home with mum and dad...The situation is unsustainable...More homes will need to be built to house our growing population."

Or maybe, as more than one reader has pointed out, we'll go back to living with our parents. Maybe this whole living arrangement of one man, one house is what's unsustainable. Houses have gotten bigger while fewer people are living in them. This is a great luxury, if you can afford it. But maybe this allocation of our collection resources is no longer economic, especially as houses are not a productive asset, but one that you consume.

Besides, for tens of thousands of years human beings lived and evolved together because we needed each other...to hunt, to defend against rival tribes, to sing, to dance, and to raid our neighbours and steal their warm pelts. Maybe life has more meaning when other people need you and you live in small groups. Maybe sitting in front of campfires with the tribe is better than sitting in front of LCDs alone.

On a statistical rather than philosophical note, the ABS also reports jobs data today. With banks raising interest rates and petrol and food prices up, the last blow the economy needs is rising unemployment. Still, you can sense the worm has turned psychologically.

Consumers will spend less because of marginally higher food and petrol prices. But they will also spend less because they are more worried and less confident that a year ago. That's not a recession. But it could take some pressure of the RBA to raise rates later this year. July CPI figures come out in a few weeks. By then, the rate picture for the rest of the year should be clear.

BIS Shrapnel's mining research unit says the next five years will be good for oil, gas, coal, and iron ore, but perhaps not as good for zinc, lead, copper, and nickel. New production for some Aussie commodities is in the pipeline. That increased supply will bring down prices for some commodities. But in others, there still hasn't been enough Aussie investment to meet growing demand.

"We didn't really do enough investment, with the benefit of hindsight, through the 1990s to gear ourselves up for maintaining strong growth in mineral output and what we're trying to do now is catch up," says BIS Adrian Hart. "The next five years will all be about increasing production to meet demand from China and other emerging economies... and once that production comes on stream that will drive weaker prices for a lot of commodities."

Al and Gabriel (the dynamic duo from Diggers and Drillers) concluded that at least one Aussie coal producer was sitting smack dab at a perfect buying price this morning. They are putting out a special buy alert on it. Coal stocks are falling, along with nearly everything else. But coal prices are still looking pretty bullish long-term, making this a great time to be selectively brave, providing you can get the right entry price.

New mines and factories are probably better long-term investments for Australia than new houses. Business investment creates incomes and jobs. Consumer investment in housing creates huge home loans that many people will never pay off if they've bought at inflated prices.

The two pillars of the U.S. mortgage market, Fannie Mae and Freddie Mac, wobbled again yesterday. The U.S. market shuddered. It shows you how important mortgage finance has become to the whole U.S. financial system, and how precarious things are today.

Shares in Freddie were down 24% yesterday while Fannie's shares fell 13%. Investors are now convinced that the firms are going to have to raise new capital and that existing shareholders face massive dilution.

"The solution to pollution is dilution," is an old phrase explaining how the negative effects from a given event can be muted if you disperse them widely enough. Think of waving your hands to disperse the smoke over a hung of burning meat loaf.

Alan Greenspan basically believed the same thing by saying that derivatives allowed for "disaggregated credit risk." Instead of one or two institutions bearing all the risk, everybody owned a little bit. This was supposed to be better global risk management.

Today though, people are beginning to wonder if it was all an elaborately worded hoax. The trouble is that Fannie Mae and Freddie Mac may not have enough capital to cover losses on the mortgages they own and have guaranteed. A bank's capital is basically its cushion against future losses. If the losses greatly exceed the available capital, you're not sitting on a cushion. You're sitting on a black hole.

Fannie and Freddie have trillions of dollars in assets. But remember, a bank's assets are someone else's liability-a loan is a promise to pay. The trouble for Fannie and Freddie is that combined, they own or have guaranteed over US$5.3 trillion in debt and securitised mortgages. Their capital, on the other hand, is slender by comparison, with Fannie having US$38.8 billion in capital and Freddie US$16.3 billion.

Many of Fannie and Freddie's assets are held in off-balance sheet vehicles. That means the banks don't have to boost capital to protect against asset losses since the assets aren't official. They are more like illegitimate children that are maintained in a second home, technically existing but not officially acknowledged. Yesterday's big hubbub was based on what would happen if the GSEs had to move those assets on to the balance sheet (move the kids from the mistress into the household with the wife and kids from the Christmas cards). Near- panic ensued.

The longer-term and not at all trivial or amusing question is how fundamentally sound are the assets owned and guaranteed by the GSEs? The GSEs have a lot of subprime debt that was issued late in the game to the riskiest borrowers. They say they can hold to maturity and don't have any need to sell it.

But what about the soundness of the rest of their portfolios? According to the credit market action yesterday, the answer is that those portfolios appear "increasingly less sound, or at least much riskier." Fannie sold US$3 billion worth of bonds this week to finance its mortgage operations.

Those two-year maturity bonds were priced at a 3.27% yield-which is nearly three quarters of a percentage (74 basis points) higher than what U.S. Treasury notes of the same duration pay. Both yields, by the way, are probably still less than the rate of actual U.S. inflation, hence negative real interest.

"You wanna borrow money Fannie? You're gonna pay." That's what the market's telling us. That spread between Fannie notes and U.S. Treasuries is the biggest since 2000. And the cost of insuring Fannie and Freddie debt against default has gone up too.

We will not ruin your day by discussing credit default swaps in detail. But think of it this way, when you get in a car accident, your insurance premiums go up. Rising credit default swap rates are the market's way of telling us it thinks Fannie and Freddie are more likely to get in an accident, so the cost of insuring their bonds against default has gone up.

All of this is enough to make the market-and anyone who owns debt guaranteed by the GSEs-very very nervous. Incidentally, we've asked APRA if anyone in Australia keeps track of which Australian banks own GSE debt and how much. So far, no luck. If things get worse, we'll find out the hard way.

Finally, for those of you who have questions about the note we sent out yesterday regarding our small cap letter, we'll do our best to respond. There were a lot of inquiries. In Daily Reckoning terms, we'd say we're looking for "positive black swans"-low probability buy high magnitude investment returns from game-changing disruptive technologies (especially in energy).

By the way, of course it wasn't hard to guess which company we were talking about in our letter. As you may have guessed by now, we're not trying to conceal anything. We're trying to be as transparent as possible.

What we are trying to show you is an example of how think as long- term investors and the kinds of investment ideas we aim to produce each month. If that looks interesting to you, great. If not, no worries. You'll still get our free Daily Reckoning every day, for what it's worth.

Dan Denning
The Daily Reckoning Australia

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