GSEs: The Tail Wagging the Credit Market Dog?

Despite some relief from the Central Bank and relaxed capital controls on the Government-Sponsored Enterprises [GSEs], the subprime induced housing recession has caused a significant supply/demand imbalance for GSE and non-GSE mortgage-backed paper, and has precipitated a global margin call of titanic proportions. The continued de-leveraging of a whole host of financial intermediaries, most notably, investment banks and hedge funds seems likely to continue for years, given efforts to introduce more stringent capital controls over investment banks in return for access to the discount window, and the concomitant reduction of lending to hedge fund and corporate clients alike.

The softening of the economy and pressure on credit spreads is being further exacerbated by a simultaneous, but not unrelated, collapse in the U.S. dollar. In the eye of the storm are the highly levered (albeit less than a few years back) GSEs known by the monikers Freddie Mac (FRE) and Fannie Mae (FNM), whose combined balance sheet is close to $2 trillion, in addition to guaranteeing another couple trillion or so Mortgage-Backed Securities [MBS]. The mortgage credit crisis is incinerating even what appeared to be reasonably levered players, with consequences that were vastly underestimated by even some of the smartest investors in mortgage-related assets. The fear levels are so high that the spreads on GSE backed MBS paper, though off the widest, are still close to 200-basis points, and exceed materially the expected default levels for the underlying mortgages.

Stockholders of the GSEs common are feeling the brunt of the pain, as few investors see a way out of the mess, The stocks of the GSEs (now well-off the lows) are still trading at the lowest levels since the mid-Nineties. They are currently priced for liquidation (i.e., book value), which is a valuation level that has only been reached a few times in their history. For financial institution stocks, a discount to book value presumes that the business will destroy value over time (i.e. not earn the cost of capital) let alone reap rewards of some “intangible” value. Given the remoteness of a liquidation of these institution’s balance sheets and the likelihood that selling will overshoot on the downside, how should investors think beyond this global margin call?

Shareholders may need to be patient (and often risk careers) in the face of the such unusual illiquid market conditions and pessimistic psychology, but one doesn’t have to make heroic assumptions about credit costs, housing price stability beyond 2009, cost of capital, spreads, and litigation and accounting expenses to make a convincing case that we are closer to the end than the beginning for the stocks, and investors in Fannie and Freddie could reap substantial above-market returns over the next three to five years, even after the March rally.

The 15% to 25% (peak to trough) decline in housing prices which is certainly a reality in some markets, and a distinct possibility in others, would not in and of itself, necessitate a liquidation of the GSE portfolios. The original loan to value [LTV] on both the on and off balance sheet portfolios are low enough to provide a substantial cushion for security holders. And, assuming some of the supply/demand for MBS eases and some semblance of normality returns to the mortgage market by 2009 through reduced prime and jumbo mortgage rates, housing prices should stop declining by 2009.

Some of the savviest (and largest) fixed income institutions have argued (rightly so in our view) that current price levels are providing the best opportunities in the municipal and mortgage credit markets in over twenty years. And they have put their money where their mouths are with substantial overweighting of MBS versus Treasuries, corporate bonds or other fixed income asset classes. How should equity investors view their chances?

There are parallels to this extreme in market psychology. In the early Nineties, during the S&L crisis the GSE stocks declined almost two thirds peak to trough. On the opposite side of the valuation spectrum during the period in the late Nineties, valuations peaked at around six times book value, an unusually risky level for financials. In the late Nineties, there was virtual unanimity (among the sell side at least) that the stocks were not expensive even though they were priced for perfection, and traded at close to 3x the current prices.

At that time, GSE spreads over Treasuries were the also unusually tight and stayed that way through the refinancing boom of the early part of this decade. Using our imputed valuation methodology, we estimated that GSE’s needed to generate 25% a return on equity (ROE) practically into perpetuity to merit a six times price/-book valuation. That computation also suggested that investors didn’t allow much room for provisioning more for credit losses or reductions in leverage (nearly 98% debt/capital at that time).

If we fast forward to 2008, investors are faced with almost the exact opposite set of circumstances. And, serious longer-term investors have to be thinking about what could go right, given that the market is discounting a very bearish scenario for housing prices, credit losses, mortgage spreads, capital and funding costs.

After examining the relevant sell-side research, it’s pretty conclusive that there is unanimity that the stock should trade at or around book value. But, book value now is a moving target (mostly lower) with per-share write-downs on a quarter to quarter basis mostly attributable to mark-to-markets (“marks”) on the MBS portfolio and other derivatives, and to a lesser extent, ongoing operating losses of a few billion annually. However, as well-acknowledged by even some of the most thorough and insightful sell-side analysts, aided by their fixed income MBS analytical teams, the methodology used to price the various mortgage derivatives is rather imprecise and relies on indices that track baskets of sub-prime mortgage and Private Label Securities [PLS], but that don’t even have active markets for the cash bonds.

But those that believe one can extrapolate from current results forward-looking returns, spreads, margins; ROE’s and the like far beyond the next few quarters are exhibiting an intellectual blind-spot for past periods of stress in the mortgage sector. While history doesn’t repeat itself, it often rhymes. It’s the pressure on analysts in the hedge and mutual funds as well as on the sell-side to explain the unexplainable (i.e. every short term movements in prices), which adds to the volatility, confusion, and mis-information. Rampant speculation has pushed trading volume off the charts, and indications are that there is very little conviction by this class of traders.

Admittedly, it’s been a one-way street for the stocks, and trend following always works, until it stops. But by betting on the long term health of the U.S. mortgage and real estate industry, investors are in good company. The largest shareholders in the Fannie Mae and Freddie Mac stock are Capital Research and Management. According to our research on public filings, its assets base grew the fastest of the major mutual fund families during the collapse of the Internet/tech bubble, and it has amassed stakes well into the double-digits for Freddie Mac and Fannie Mae.

Comments

[Daniel Jones]

What's the worst-case scenario if the book values continue to erode? JP Morgan can't come in and buy FRE or FNM for $10 a share...these two will have to access the capital markets and pay up for that capital. That usually means a dilutive event for present shareholders. Does the present market price reflect this potential?

I like your analysis of the historical price / book. Are there other, smaller regional players in the banking sector that represent compelling price / book opportunities?

[FIG trader]

1) Market reflects bad news, needs housing price stability. But, worse case scenario is behind us; a 1/100 year crisis of confidence event in the credit markets/mortgage paper.
2) reversing 2/3 of the MBS mark to market (non-subprime) probably a gradual 12-18 month event
3)Capital will be costly, and it is a race against time, the wider the spreads and deeper discount to book the stock carries, the more dilutive the action. Conversely, if allowed to expand mortgage portfolio aggressively on the cheap and MBS spreads tighten late 2008 2009, they will print money in 2009/2010/2011 and beyond. Lots of thrifts well below book (most of them in fact, of special interest are those based in California). This is the safest if there is another big leg down (which I doubt, but you never know)

[jimmy46]

UGH, you spent 2000 words to say nothing

[Richo]

Disagree.

Due to median income vs cost of living and consumer debt load the average consumer only has so much housing debt capacity.

At the height of the boom loans were granted without regard for the consumers ability to pay.

Home prices will fall until the median home reaches 2.5 x median wages.

Another contributor to home price collapse, especially in the most frothy, speculative, markets is the current tightening in lending qualifications.

The imposition of a down payment requirement eliminates a good percentage of potential buyers.

The return to a combined maximum 45% (housing PITI + consumer payments) / verified gross monthly income will bring housing prices back into alignment with median imcome.

In the intrum that leaves us with a giant overhang of over leveraged, underwater debtors. Many with poor histories of repayment.

Until this resolves any company with exposure to the inevitable wave of mortgage defaults and housing price correction is a risky bet.

How long before we have a bottom? With all of the "prop up the market" shenanigans I do not know the WHEN but we will be getting there when we see the above 2.5 x median income for median housing.

My guess is after the option arms resolve themselves. Pretty interesting bulge of them out there in 2010.....but I suspect they will come into play before then.

Good luck

[FIG trader]

Jimmy, sorry grunting doesn't count as a legitimate response. I'll try to keep it to one syllable words for you next time.
Richo, Not sure what your disagreement is. Most of your points are correct though don't address the implied methodology for valuing the GSE's. To repeat, it is a bet on stabilization of house prices (reasonable 15% to 25% below national peak price levels), resumption of more normalized spread levels on MBS (GSE and non GSE backed) by 2009/2010, return to 8% to 10% mortgage credit nationally (more than 30 years of history on that), and absolute levels of mortgage rates stabilized below the 6% to 7% range for several years. Somewhat optimistic, but not unreasonable given it will be top of policy agenda (and should be). I am taking cues from Pimco's view on the necessity of multi-pronged policy response to stabilize house prices, and the GSE
s well collateralized guarantee book.