The Daily Reckoning
Weekend Edition
December 25-26, 2004
Baltimore, Maryland
By Addison Wiggin and Tom Dyson MARKET REVIEW: CHRISTMAS TURKEYS It's Christmas. We're in New York. The feet are elevated,
the wine's fortified and for the first time in 8 weeks, the
food hasn't been fried. And other than the credit rating of
Fannie's preferred stock, keeping warm is the only real
concern... On Friday, Fitch Ratings lowered Fannie's credit rating by
one notch, amid concern that it might not be able to pay
dividends next year. And even more troubling, Fitch says
they'll downgrade Fannie's debt much further should
dividends actually become suspended. Dividend suspension is a very real possibility. Dividends
are decided by the Office of Federal Housing Enterprise
Oversight (Ofheo) and can only be paid out if Fannie is
healthy. But Fannie is not healthy. On Tuesday, Ofheo said
the giant mortgage company was 'significantly
undercapitalized' and ordered it to raise some $3 billion
in additional capital by June. Raising capital can be done in a number of different ways.
Fannie can simply issue more preferred stock, or even
liquidate some of its mortgage portfolio. This is where
credit ratings are important...the better your rating is,
the less interest you pay on your debt. So every time they
cut Fannie's rating, her financing costs increase. This is a big deal, dear reader. But don't take our word
for it...just ask Franklin Raines and his chief financial
officer, Timothy Howard. These two book-cookers are now
unemployed. Just two days ago, they were at the head of the
table, now they're the main course - a pair Christmas
turkeys if you will. Two days ago, they ran the finances of
a company with assets over $1.6 trillion. Now they're at
the center of a crisis...a crisis that could easily become
the greatest in America's financial history. Or ask St. Louis Fed president, William Poole. "It does
seem to me," said Poole in a recent speech in Chicago,
"that investors have priced these obligations under the
assumption that there are no possible risks that might
strain GSE capital positions. This is exactly the behavior
that has preceded the classic crises described by
Kindleberger." "In my opinion," continues Poole, "GSE capital positions
are undesirably thin and leave these firms unnecessarily
vulnerable to surprise shocks. There is no way to predict
what kind of shock might shake market confidence, but the
reason a shock could have serious adverse effects is that
GSEs pursue a strategy of borrowing short and lending long
with a thin capital margin." Market confidence remains intact, for now. In fact, this
week, the major indexes all hit major multi-year highs. The
Dow closed the week at 10,827, a new three-and-a-half year
high. The Dow's highest ever reading was taken in January
2000, at 11,908. In June 2001, it was back above 11,000
again. But it didn't stay there long...and has never been
back since. Nevertheless, Mr. Market is fighting back, and on the eve
of 2005, the Dow's only down just over 9% from the all-time
high. For comparison, the S&P is down 22% and the Nasdaq is
down 58%. The markets maybe showing strength at the moment, but the
same can't be said for everyone. "Since this latest Fannie
story broke, the phone's been ringing off the hook," says
Addison Wiggin. "I suddenly find myself inundated with
interview requests. Fannie Mae is the only thing these
people want to hear about. I'm definitely starting to feel
a degree of panic that just wasn't there before." Fannie may be crumbling, but it is Christmas. So we shall
forget the 'structural imbalances' and 'rating
downgrades'...for now! We suggest you do the same. Pour
yourself another glass of sherry, dear reader, and have a
smashing Christmas, Warm regards, Tom Dyson
The Daily Reckoning P.S. This might be late-breaking headline news for the Wall
Street Journal and USAToday, but we've been all over this
story like white on rice. In fact, Eric Fry, editor of the
Rude Awakening, wrote, on July 9, 2003, "Fannie Mae, like a
great-tasting, non-fat dessert, is simply too good to be
true." (You'll find the complete Fry essay in Flotsam and
Jetsam, below). Since that essay, over a year and half ago, we have yet to
let the trail go cold. Dan Denning, editor of Strategic
Investment, has been our most vociferous editor. "If I were
to tell you of a business - any business - that had racked
up over $5.7 trillion in liabilities against $1.2 trillion
in assets, you'd be a bit skeptical of their long-term
prospects, wouldn't you?" he asks rhetorically. "And if I also told you that this total of $5.7 trillion in
liabilities was built up during a time period when the
borrowers responsible for those liabilities were more
likely to default on their obligations than at any point in
history...well, you'd certainly avoid buying shares of this
company." For more on the implications of a full-fledged
Fannie bust... click here:
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offer will expire! http://www.agora-inc.com/reports/GRP/gripC00 ------------------------ THIS WEEK in THE DAILY RECKONING OVER THE TOP
By Bill Bonner "'But we have had a very good year. We made money; probably
more than we deserved. But there is a time and a season for
everything. For many, many years we made less than we
thought we deserved. Everything tends to balance out in the
long run.'"
http://www.dailyreckoning.com/body_index3.cfm?id=11110 MYTHS AND MISDEMEANORS
By Carl Waynberg "Why bother with ROE at all? While ROE can be deceptive, it
can also indicate how effective management is at wringing
profits out of its operations. Companies that do well at
this, tend to have a distinct advantage over their
competitors, which tends to translate into superior price
performance."
http://www.dailyreckoning.com/body_index3.cfm?id=11108 CANARY IN A COALMINE 12/22/04
by John Mauldin "Hmmm. A strong housing market that might be peaking. A
central bank that has been raising rates. A solid economy
with inflation starting to pick up. A stock market that
looks like it may have peaked? Oh, and did I mention a very
large trade deficit? Sound familiar, my fellow countrymen
and women?"
http://www.dailyreckoning.com/body_index3.cfm?id=11104 THE SPECTRE OF DEFLATION 12/21/04
By John Calverley "A world of very low inflation, and potentially deflation,
makes the current house price bubbles more dangerous than
in the past and, from an investor and homeowner point of
view, means that houses are a more risky investment. After
past price bubbles, house price adjustments were limited in
nominal terms by the cushion of high underlying inflation."
http://www.dailyreckoning.com/body_index3.cfm?id=11092
DON'T DO US ANY MORE FAVORS 12/20/04
By The Mogambo Guru
"Only a real first-class bozo could possibly believe that
the election could not be "fixed," and only a nation as
full of morons as the United States would roll over for
such a thing without even a whimper. And if the American
people are so incredibly naïve and stupid as to allow such
a transparent fraud in something as simple as an election,
then pulling the wool over their eyes as far as economics
is concerned is going to be a breeze!"
http://www.dailyreckoning.com/body_index3.cfm?id=11074 ---------------------- HEADLINE, NEWS And INSIGHT: How Long is a Minute?
by Graham Summers
"So while all of these kids were working themselves into a
frenzy, I simply stood there counting and clicking to
myself. I knew I had a method that worked, and I didn't
need to worry about anything. Sure enough, I was within a
second and a half of an actual minute, and I won, hands
down."
http://www.dailyreckoning.com/body_headline.cfm?id=4360 --------------------------- FLOTSAM AND JETSAM: DISROBING FANNIE MAE 07/09/2003
By Eric J. Fry
Last week, a French reader of the Daily Reckoning inquired,
"Bonsoir, J'aimerais bien connaître l'opinion de M. Eric
Fry en ce qui concerne Freddie Mac et Fannie Mae, les
grandes firmes americaines de contrat hypothecaires.
Merci."
Translation: I'd like to know Eric Fry's opinion about
Freddie Mac and Fannie Mae, the large American mortgage
companies. I was flattered that a Daily Reckoning reader - and one who
is neither a relative nor a close friend -- would solicit
my opinion. But I will demur. No opinion is forthcoming,
but I will happily provide a series of skeptical
observations about the widely adored mortgage lender. To
preview, my observations cause me neither to like or to
dislike the company's stock; merely to fear it. It is not easy to become rabidly negative about a stock
selling for nine times earnings. But that does not mean
that it is difficult fear it. Fannie Mae, like a great-
tasting, non-fat dessert, is simply too good to be true.
Beginning with its privileged status as a government-
sponsored enterprise (GSE) and ending with its impossibly
consistent earnings history, there is almost nothing about
this financial behemoth that is NOT too good to be true.
The company is a financial marvel. When a mortgage-lending institution grows its earnings
year-after-year at a rate that is several times faster than
GDP growth, something is too good to be true, especially
when that spectacular growth rate coincides with an equally
spectacular increase in debt and balance sheet leverage.
And what should we think about a mortgage-finance company
that produces consistent, non-volatile earnings growth,
despite the fact this growth cohabitates with an imposing
Kilauea of volatile interest rate derivatives rising up
from its balance sheet, or from some location perilously
close to its balance sheet. And yet, somehow, this behemoth produces perfectly smooth,
consistent earnings growth year after year. How does this
happen? Is it magic? Or just brilliant management?
Investors must believe it is the latter, or they would not
have awarded Fannie Mae with a premium valuation relative
to other mortgage lenders and financial institutions.
Fannie's stock sells for nearly four times book value.
Citibank and Bank of America, by comparison, both trade for
about two and a half times book value. "Fannie and Freddie both engage in some form of 'earnings
smoothing,'" says Apogee Research's lead analyst Robert
Tracy, who has for been digging deep into the financials of
Fannie Mae and a couple of other well-known GSEs.
"Naturally, senior officers at these companies eagerly
justify their unusual accounting practice as something more
'accurate' and 'helpful to investors' than conventional
GAAP accounting. But that assertion is highly debatable,"
says Tracy. "One thing is certain, however, their
cosmetically enhanced earnings have been helping to boost
their share prices and valuations. And a higher valuation
means much larger paydays for the heavily optioned
management." Tracy suspects that the era of earnings "smoothing" may be
drawing to a close, and if so, the bull market in "managed
earnings" is also winding down. Which means that the
premium valuations achieved by the masters of the managed
earnings - i.e. folks like Fannie Mae - will fade away. "By its very nature, the mortgage finance business, which
extensively uses derivatives to hedge various forms of
interest-rate risk, will experience erratic trends in GAAP
earnings," Tracy continues. "To smooth out the reporting of
those GAAP trends, both Freddie and Fannie turned to pro
forma disclosure, a method whereby Fannie designated its
pro forma numbers as 'core business earnings' and Freddie
used the term 'operating earnings.' They encouraged the
investment community to focus not upon their GAAP earnings,
but rather on pro forma disclosures that excluded certain
items, most notably the impact of changes in the valuation
of derivatives. "Over at Fannie Mae headquarters, management continues to
cling to its preferred version of earnings, what it calls
'core business earnings.' I guess you can't blame 'em for
trying to put the best spin on things -- so long as they
can get away with it. Fannie's pro forma treatment dishes
up a more pleasing and consistent earnings trend than the
erratic swings you get with GAAP. Then, too, for the past
six quarters, Fannie's reported GAAP earnings totaled $8.5
billion, while pro forma net income totaled $9.7 billion.
Who wouldn't want to claim an extra $1.2 billion of
earnings? You have to admit that from Fannie's perspective,
pro forma is a win-win situation: Not only do the earnings
appear more consistent, but, all of a sudden, there's $1.2
billion more of them!" "So is all the bad news out on the GSEs?" I asked the
Apogee analyst. "After all, Freddie Mac's own Chairman,
Shaun F. O'Malley, declared on June 25, 'The company
remains safe and sound.'"
"I don't believe him," Tracy replied. "I don't think he's
lying. But he may be mistaken. Investors still do not have
access to enough detail about the company's finances to be
able to invest confidently in its shares." In other words, in the case of the GSEs, ignorance is not
bliss. "What, for instance, would have happened had Freddie bet
the wrong way on interest-rate movements," Business Week
asks provocatively, "or if banks, fearing further problems,
refused to buy its debt? Freddie's problems reveal just how
little is known about its inner workings -- and highlight
the risks should the markets lose confidence in its ability
to manage its huge derivatives portfolio." If these companies weren't so big, we might not care how
they account for the thousands of derivative contracts on
their books. But Freddie and Fannie are not merely part of
the housing market, they are the housing market. "Fannie and Freddie now carry an astronomical $1.6 trillion
in assets on their balance sheets, up from $962 billion in
1999," Business Week notes. What's more, based on the Fed's
recent flow-of-funds report, a whopping 77% of total U.S.
financial-sector debt outstanding as of the end of this
year's first quarter resided with the GSEs, federally
regulated mortgage pools and the asset-backed issuers. "These are the very folks at the direct heart of, and
largely responsible for, the bulk of current credit
creation in our economic system," observes Contrary
Investor. "Many of these financial-sector participants are
also significantly leveraged to derivatives as part of the
risk-management component of their credit-creation
operations. And these folks are operating completely
outside of the regulated U.S. banking system." Not surprisingly, these two lending giants also wield a
giant-sized influence over the U.S. economy. Last year,
refinancing activity put an extra $100 billion dollars in
consumers' pockets and that pace has accelerated this year,
thereby offsetting a sever drought in capital spending. If
these two companies can almost single-handedly support the
economy, couldn't they single-handedly pull it down? Is it an exaggeration to infer that a serious problem at
either one of these two companies would have serious and
worrisome implications for their share prices, the housing
market, the bond market, the US dollar and the US economy
in general. "What a mortal can easily see," says Jim Grant
of Grant's Interest Rate Observer, "is that a Freddie
accident would be a dollar accident as well as a corporate-
finance accident." In other words, containing financial
market volatility is a little bit like herding cats. Who
can say what sorts of traumas may result from the brave new
world of volatility at Fannie Mae and Freddie Mac. Lower
share prices would seem to be the best-case scenario. "I'm hoping for the best," says Tracy, "but I fear the
worst. Now that two prominent members of the GSE family
have come under the harsh light of disclosure, it's only a
matter of time before their share prices reflect the real-
world volatility and uncertainty of their earnings results.
'Uncertainty' is just another way of saying, 'falling share
price.'" The Housing Bubble Goes Pop!
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