July 4, 2010
If you're a regular reader you know we thought Fannie Mae was, as far as stock picks go, a darn good bet.
But we were wrong.
On June 16 2010, we almost fainted when we received the announcement that Fannie Mae and Freddie Mac would be delisted from the NYSE, wiping out shareholders.
As far back as 18 months ago we thought Fannie was like holding two tens in blackjack against the dealer's sucky five card. But to see the dealer turn over a six followed by five twos was shocking when only one deck is being played.
Bloomberg's Tom Keene put it best when he said "it struck me like a thunderbolt." Nothing is certain in betting or investing, but when the rules change during play it really stings.
To be sure, Fannie Mae was a wildly speculative investment. Any stock hovering around $1 is. But considering FNM holds assets worth trillions and holds 95% of US mortgages and is therefore key to the future of the US, that's a beautiful $1 stock. Or so we thought.
Another important factor we considered was that the government had been previously successful with monetizing their investment after buying up to 79.9% of other companies. AIG is a perfect example. AIG did a reverse stock split to escape NYSE's rule that you stocks must de-list if they trader under $1 for more than one month. The US, we thought, had developed a model that worked out pretty well for everybody but it was the government itself who requested the de-listing, not Fannie Mae.
We considered other persuasive factors when we bet that FNM would survive.
There was the announcement on Christmas 2009 that the government would back Fannie Mae unconditionally. If a blank check from the government itself couldn't get Fannie Mae through the next year what could? Even more recently, key signals suggested the mortgage market will continue to deteriorate. Our belief that Fannie would remain on life support past the election were stronger than our belief that Apple would beat next quarter's earnings estimates.
And yet, without fanfare or warning, Fannie was suddenly euthanized. Holders of Fannie stock, ourselves and Calpers included, were treated to an unpleasant coup de grace.
There were scant clues that Fannie would be delisted. In the three weeks leading up to the news, there was a sudden proliferation of anti-Fannie rhetoric on Twitter by people we've never heard of before. More notably, FNM traded flatly in the two days of trading prior to the announcement when the market was up considerably. (Many heavily traded stocks go up when the market is up, absent negative news). We missed the WSJ Op-ed by Steve Blumenthal, Fannie's regulator, two days prior which apparently suggested the government should do a full take-out and buy the remaining 20.1%. De-listing was a cheaper alternative, apparently.
Immediately after the shocking announcement our favorite economist of all-time, Tom Keene, interviewed Paul Miller from FBR - a defacto expert on the housing market. Mr. Miller skirted Mr. Keene's critical question on whether the markets should calculate FNM's debt onto the Fed's balance sheet. If anyone could answer that all-important question it would be Mr. Miller. But he didn't. Instead he took the sneaky way out by saying "for overseas...I don't think they completely understand it [the accounting] so it's done to keep it off the balance sheet." If you've read Ken Posner's "Stalking The Black Swan" you know Miller's answer could be a critical clue that something highly concerning is lurking.
We recall a similar situation in March 2009 when the preferred shareholder's of GM were wiped out without regard for contract law or legal precedent. We thought that was crazy. But the eradication of Fannie Mae is crazy to the power of n.
One thing that really gets us and still hasn't been explained is this: how can the government violate GAAP accounting to such an unbelievable extent? The Fed didn't violate GAAP accounting rules when they took Fannie over, so why violate the rules now? What's changed? Has the recent onset of the dramatic Eurozone crisis paved the way for strictly-enforced accounting standards to be cast off like some homeless crack addict?
The long-standing accounting rule to which we refer has not been changed or modified, to our knowledge. It states that if one entity acquires 80% of another entity the balance sheet of the acquired entity must be consolidated on the buyer's balance sheet. It's standard procedure. It's a gimme.
That's why the government purchased 79.9% of Fannie Mae and not 80% because 80% would trigger a behemoth amount of debt and toxic assets that would legally have to be recognized. We're talking trillions of dollars in assets and $1.5 trillion in debt, not to mention the mega-trillions in mortgage backed securities and who knows how many other debt instruments. The impact of consildating Fannie's balance sheet is not just astounding, it's unfathomable.
So we thought Fannie was a nice little stock waiting to happen. Kind of like KKR's NYSE listing when it was 0.85 (KFN). It went to $7 in a heartbeat. We were in on that and we loved it.
Taking on Fannie Mae's toxic wasteground would effectively double the debt level of the US, sending the bond markets into a tailspin never before seen. The pro-forma debt to GDP levels of the US would make every country in the world look like Olympic athletes by comparison. But maybe numbers don't matter anymore.
Obviously this has not been lost on whoever is in charge these days. We haven't heard from Gheitner in a long time. Obama and Volcker are the new face of American finance while, we suspect, Gheitner is coordinating the design of a global debt reset button.
Is there another alternative to re-booting the US mortgage computer? Since Michael Moran of Daiwa Securities doesn't think there will be further expansion of the Fed's balance sheet, this suggests Fannie Mae will remain, well, off the balance sheet. This would be a neat trick.
Is calling a mulligan on hundreds of trillions of dollars in global debt a scenario that is even possible? What would be the ramifications for the thousands of institutions inextricably enmeshed in the fixed income markets? Everything from Mortgage-backed securities to synthetic CDOs to high-yield and senior notes would be affected. If there was such a plan, you'd think we would have heard something by now. It's kind of a big deal.
Kind of like Fannie Mae going bust out of nowhere.
Frankly, we're not sure where to go from here. Our confidence is shattered. When Fannie received explicit financial suport of the US we figured it was as good as the inscription that appears on every dollar bill in America: backed by the full faith and credit of the United States.
The only conclusion we can draw is that it's impossible to know what to believe or who you can trust anymore.
Heaven help us if the US dollar isn't worth the paper it's printed on.
If George Soros is reading this: reflexivity has suddenly become the new economic model.
-- The New York Nickel
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Disclosure: No Position - forced to sell
July 4, 2010