UncleLongHair

Why I Bought Abbott Laboratories Despite Health Care Reform

>>> It is no secret that our dear leader, a friend of the common worker, whose presidential campaign was paid for by unions, has been repaying his socialist backers <<<

At this point I stopped reading. Is this an investment idea or a political OpEd piece?

Fannie and Freddie: The Heat Is On

You have a bunch of hedge fund managers claiming that it is very likely that FNM and/or FRE get bailed out by the end of Q3. What significance does that date have? Oh yeah that is the date at which their portfolios are marked to market for their performance bonuses.

Did Fannie and Freddie Cause the Mortgage Crisis?

>>> Freddie and Fannie have untold billions of subprime loans on their balance sheet. BILLIONS AND BILLIONS. <<<

I've heard this hysterical statement uttered frequently in reference to FNM and FRE, which I think demonstrates the basic misunderstanding that many people have, both laypeople and professionals, about FNM and FRE.

First off, FNM/FRE's subprime exposure is not "untold". It's clearly reported in their investor presentations. Here's FRE's latest, from this month:

freddiemac.com/investo...

Page 42 shows their retained portfolio breakdown, and that about 13% of their retained portfolio, about $92B, is in sub-prime mortgages, and these have on average a 37% credit enhancement.

Second, many people hysterically scream "billions and billions" implying that the exposure is endless and fatal. Let's look at the numbers. A billion is a big number. A trillion is an even bigger number. FNM and FRE have guaranteed about $5.2 trillion of mortgages. One billion is 0.02% of that. FRE's $92 billion of retained subprime mortgages is 2% of that. The exposure is simply not enormous.

Subprime issuance has come almost to a complete halt, and subprime mortgages tend to prepay very rapidly, so within a year or two I expect FNM and FRE to have very little sub-prime mortgages in their portfolio.

Bill Ackman's Plan to Save Fannie and Freddie

Successfully shorting another company 5 years ago doesn't give him the moral high ground when trying to line his pockets again. He tries to wrap himself in the shroud of a do-gooder, but he's just out to make a buck.

The SEC just issued subpoenas to short sellers investigating market manipulation, I wonder if Ackman is on the list. I bet he is.

Did Fannie and Freddie Cause the Mortgage Crisis?

You raise some interesting questions, the answers to which I suspect are not cut and dry.

>>> For my part, I have two questions for those who take the position that the GSEs played no significant role in causing our current mortgage problems. <<<

That is not my position, but I've got an opinion on everything.

>>> First, what economic justification is there for the dramatic increase in the share of loans guaranteed or held by the GSEs between 1980 and 2003 that is seen in the first graph presented above? What sense did it make to increase the ratio of such loans to GDP by a factor of 12 over this period? <<<

I guess you're asking why the GSE's increased their market share during this period. I guess the obvious answer was because they could -- they're for-profit enterprises, and increased market share can lead to increased profits if that business is properly written (i.e. proper risk-adjusted returns). Perhaps I'm misunderstanding the question.

To me, FNM and FRE generally guarantee the most conservative and basic mortgage products that exist in the country, and seeing their market share increase is a source of comfort, rather than alarm, because it means that a greater portion of the country's mortgages are conservatively financed and underwritten properly.

In fact, I believe it was the decline in the GSE market share starting in 2003 that foretold the mess that we're in now, because other, more reckless and less stable companies took market share from the GSE's, leading to a higher proportion of risky mortgages in the system.

Another data point to consider is that the default experience on mortgages written from about 2000 to 2005 has been far less than those written in 2006 and 2007 (for a snapshot of these numbers, look at FRE's recent investor presentation which shows cumulative defaults by year). It's the 2006 and 2007 loans that are the major problem. The loans that were written when FNM and FRE were at their recent market share peak are performing well. I think this indicates that FNM and FRE are part of the solution, not part of the problem.

>>> Second, what forces caused the explosion of private participation in a much more reckless replication of the GSE game? A year ago, I suggested one possible answer-- private institutions reasoned that, because the GSEs had developed such a huge stake in real estate prices, and because they were surely too big to fail, the Federal Reserve would be forced to adopt a sufficiently inflationary policy so as to keep the GSEs solvent, which would ensure that the historical assumptions about real estate prices and default rates on which the models used to price these instruments were based would not prove to be too far off. <<<

Once again, it's a free market, and these companies thought they could make a lot of money playing the GSE's game. But they had a permanent disadvantage in funding costs that they had to make up elsewhere, and they tried to do this by inventing new mortgage products and laying off some of the risk to the bond market. This worked for a while, which is why GSE market share declined while the non-GSE profits boomed. But that chicken has come home to roost, and, as the Wells Fargo CEO recently said, things now look normal for the first time in a long while.

Uncle

Fannie and Freddie Are Largely Responsible for the Housing Bubble

Correlation is not causation. FNM and FRE are impacted by the housing problems more than anyone else because they handled more mortgages than anyone else. If simply creating these entities "caused" the bubble, why haven't we had more bubbles over the past 70 years?

Other institutions are just as much to blame, if not moreso, than FNM and FRE, such as the reckless subprime lenders and ratings agencies that blessed their securities. Are FNM and FRE to blame for their actions as well?

>>> Clearly it doesn't take much of a writedown on 5.2 trillion dollars to wipe out any private equity that Fannie and Freddie may have <<<

The $5.2 trillion of mortgages held by FNM and FRE are not on their balance sheet, and thus can't be "written down".

Uncle

The Future for the Mortgage GSEs

These are all ideas that OFHEO has knocked around over the years in their attempt to put handcuffs on FNM and FRE.

1. Geographic diversity is one of the primary ways to reduce risk in investing in mortgages. This was the original impetus for FNM and FRE, as investors in wealthy parts of the country (i.e. Boston) could invest in mortgages in emerging parts of the country (i.e. Arizona). This allowed the country to grow in a stable and self-funded way and allow investors to spread risk. Later, it allowed regional banks to avoid being taken down when trouble hit their local economy, since they could sell their loans into nationwide loan pools. Restricting FNM and FRE to a certain region would be a major step backwards in risk control and add, not remove, risk from their business.

2. "I can't honestly say that buying a $450k home instead of a $600k home is a legitimate hardship." Unless there are no houses for sale in your region for less than $600k, in which case you must rent or move. FNM and FRE recently increased the conforming limits for certain counties, and some counties have a limit nearly twice the average (i.e. $730K vs. $417K). The country has a very wide range of property values, and FNM/FRE should have a presence in every market to maintain diversity (see #1). A high property value does not de facto lead to a riskier loan. If there are concerns about unsustainable home prices, they should enforce a lower LTV in those cases.

3. The OFHEO caps have been a disaster because they can't figure out a way to apply caps that adjust accurately to changes to the economy and mortgage environment. A fixed number cap does nothing but benefit the competitors of FNM and FRE, since the loans have to go somewhere, who are far less regulated and capitalized.

4. It isn't at all clear that FNM and FRE are undercapitalized. The people saying that the GSE's are undercapitalized are the short sellers who make money when the stock falls. The officials from the Fed, Treasury, FNM and FRE are unanimous in saying that the companies are adequately capitalized. Running through the actual numbers to QUANTIFY losses indicates that they are. This may change in a few quarters or years, but today the concerns are way overblown. That said, FNM and FRE could reduce their overall leverage ratio, and the $2.25 billion of emergency capital pledged to them by the government decades ago could be adjusted for inflation and growth in the mortgage market to make it a meaningful backstop instead of a token.

5. The GSE's were never intended to prop up or protect the economy. They were created to add liquidity and diveristy to the national mortgage market, which is both essential to the economy and cyclical. Without some kind of national support, regional economies would blow up again and again as local lenders accepted local deposits and lent the money locally and then had no recourse when the local economy went sour. No mortgage investor wants to invest in a basket of mortgages 100% on a California fault line or in the Florida hurricane path. Providing diversity and liquidity to the market reduces overall risk.

The main things the regulators could do to benefit FNM and FRE (and thus the national economy) would be to 1) ensure the "go-go" mentality that caused the overstated income and accounting scandal never returns, and ensure that the institutions are managed conservatively, 2) provide more transparency into the companies, it was only recently that they had to file the same financial statements as other major financial firms, 3) ensure that FNM and FRE are adequately compensated for their risk.

On that last point, FNM and FRE are basically insurance companies, accepting a "g fee" up front in exchange for guaranteeing a risk (mortgage default). If they are posting huge losses, they were not being compensated sufficiently for the risks they were taking, and many of these fees and risks were quantified by the government regulators. Warren Buffett recently noted that the government was asking (requiring?) FNM and FRE to take too much risk on their balance sheets. If they want them to thrive and survive, they need to reduce that risk.

Bill Ackman's Plan to Save Fannie and Freddie

FNM and FRE aren't insolvent and don't need a bailout. They're earning gobs of money on the higher spreads, lower risks, and increased market share starting a year ago when all of the fringe players in the mortgage industry were dealt fatal blows. FNM and FRE were never bottom feeders in the industry, they deal primarily in the cream of the US mortgage crop. Most analysis on the companies, like Ackman's, doesn't even take a passing glance at quantifying the default risk and how FNM and FRE can afford it, because if it did, people would realize that the situation is nowhere near as dire as the short sellers want you to think.

Everyone throws around the number of $5 trillion of mortgages guaranteed by FNM/FRE. Even after the widely publicized increase in defaults and losses, default rates are still well below 1%. Even at 1%, that is $50 billion of losses, spread over many years. This assumes default recoveries of 0%, though recoveries will be well above zero with their conservative assets. FNM and FRE currently have total capital of around $95 billion and have plans to raise another $10 billion, and have many options for raising more capital including retaining earnings (i.e. cutting the dividend). They have plenty of capital to withstand current losses, and the ability to raise more.

Ackman's plan makes sense only to himself. It looks like a teenager threw together his slide show after school, he may as well have drawn it with crayons. It is outrageous that he can short the stock, and then go on TV and politely suggest that everyone get together to restructure a company that needs no restructuring just so he can make an enormous return on his investment. The thing that would "benefit America" would be to have investors and journalists laugh in his face when he tries to pull the wool over their eyes.

The timing is no surprise, as Ackman is cranking his publicity machine during the company's quiet period, as the Q2 numbers are probably nearly done but not yet reported, and they can't comment on Ackman's stupid allegations. Ackman is all too aware of the unlevel communications playing field, where executives are limited in how and when they communicate and he is not. He also knows that simply creating fear, uncertainty and doubt (FUD) around a financial company is enough to destroy it, as happened with Bear Stearns and IndyMac.

Ackman is simply trying to initiate a "run on the bank" at Fannie and Freddie, by undermining the investment community's confidence in their obligations. This is all an extremely thinly veiled attempt by Ackman to rape the capital markets for more ill-gotten gains. Analysts and investors should simply ignore him.

Uncle

The SEC Panics

Ackman's plan makes no sense for anyone but himself. FNM and FRE are not insolvent, don't need a bailout, and certainly don't have to have their short term debt wiped out.

This is just another attempt by Ackman to create a crisis in a company that he has shorted. I'm astonished by the gall of someone who goes on CNBC, states that he is short a stock, and then politely suggests a restructuring plan that sends that stock to zero in order to "benefit America". Give me a break. I hope he loses his shirt.