John Hussman: Fannie Mae and Freddie Mac Are Secure

Excerpt from the Hussman Funds' Weekly Market Comment (7/14/08)

To begin, I should note immediately that I have every confidence that the government sponsored mortgage securities issued by Fannie Mae and Freddie Mac are secure, as are the deposits that individuals hold at FDIC insured banks. The Treasury's reassertion on Sunday that the government stands behind those institutions should make that commitment clear. Moreover, it is important to understand that the risk to Freddie and Fannie isn't that their entire mortgage portfolio, or even a significant percentage of it, will go bust. The problem is that these companies operate on about 40 times leverage, so their shareholder capital can't provide adequate buffer for the losses. We should be careful to distinguish the stocks of financial companies from those securities that are issued with the explicit or implicit backing of the U.S. government. I do believe that many financials face heavy dilution as they attempt to rebuild capital, but I continue to believe that the primary risk is to the stocks of financial institutions, particularly investment banks, and not to the integrity of the U.S. financial system itself.

With regard to Fannie Mae and Freddie Mac, it should be clear that last week's panic came as no suprise, because these institutions have always walked the tightrope on a shoestring even before mortgage defaults became an issue. A few excerpts from prior commentaries:

"I don't even understand why Fannie Mae trades at all."

"Now make no mistake, there is little question that bank deposits and agency debt are safely backed by the U.S. government and that this is a good commitment. However, the holders of stock in banks or mortgage companies like Fannie Mae and Freddie Mac may not be so secure. It's just excruciatingly difficult to perfectly match risky assets and liabilities at extremely high levels of leverage. Ask Long Term Capital. Indeed, were it not for accounting rules that allow Fannie Mae to keep balance sheet losses out of earnings, it would be clearer to investors that last summer's 5-month "duration mismatch" cost Fannie nearly a year of earnings. Similar derivatives-related issues are at the core of Freddie Mac's recent difficulties."

"The duration gap of a financial company is equal to the duration of assets minus the duration of liabilities. For Fannie Mae to have a duration gap of -14 months means that the duration of liabilities exceeds the duration of their assets by 14 months. Since -14 months is -1.17 years, this means that a 1% drop in interest rates would cause Fannie Mae's loan portfolio to lose about 1.17% in value. Now, that doesn't sound like a lot. Until you realize that Fannie Mae has leveraged its equity 40-to-1 (the highest leverage ratio in its history), and that its annual return on this portfolio is just 0.65%. In short, a further drop in interest rates of even 0.50% here would cause an overall portfolio loss equal to about (1.17 x .50 x a leverage factor of 40 =) 23% of Fannie Mae's book value, or equivalently, about (1.17 x .50 / .65 = ) 90% of Fannie Mae's annual earnings."

"As I've written many times, there are three features common to nearly every financial debacle: 1) extreme leverage, 2) a mismatch between assets and liabilities, and 3) lack of disclosure. In this regard, it's difficult to exclude Fannie Mae from concern. We don't own any stock in the company.

Comments

[adan:]

great article and info, always like seeing your viewpoints - thanks!

2008 Jul 15 09:46 AM