Figuring out Fannie

Dan Amoss - Fri 15 Sep, 2006

"...Today's financial engineering enables a group of Japanese retirees in Yokohama to finance the mortgage of a crane operator in Buffalo, a teacher in San Diego, and thousands of other Americans. But is it safe...?"

Analysing Fannie Mae is like driving without a road map
in a foreign country full of unfamiliar traffic rules.

The lack of audited financial statements (no road map)
and poor understanding of traffic rules (no precedent in
financial history) does not give one very much
conviction about the value of an equity stake in this
behemoth. So let's start with what we do know about
Fannie.

Fannie is a "government-sponsored enterprise" (GSE), but
it is owned entirely by private stock market investors.
The fact that it is "government sponsored" enters the
equation if you consider the implied US government
guarantee backing most of the bonds issued by Fannie.

Implied government backing has never been tested in a
liquidity crisis - an instance when most expect the
federal government would make up any potential shortfall
of interest and principal payments to Fannie
bondholders. So Fannie can issue bonds with a
microscopic "spread" or interest-rate premium over
Treasury bond yields. For example, if 30-year Treasury
yields were 6.2%, Fannie could issue an enormous amount
of 30-year bonds somewhere around 6.3%.

Fannie has a structural competitive advantage over all
private US institutions in the business of providing
capital for home mortgages. It is involved in the "carry
trade" business - just like most banks - whereby Fannie
floats debt at the most competitive rates across the
yield curve and invests this borrowed capital in higher-
yielding assets, pocketing the "spread" between the
rates paid by its assets and the rates paid out to its
bondholders.

The "spread" business is fairly straightforward and
hinges on how creditworthy the fixed income markets deem
Fannie Mae. As long as the 6.3-6.2% spread doesn't widen
dramatically, Fannie can underwrite as many mortgages as
the market demands, subject to limitations imposed by
its US regulator, the OFHEO. This has been a license to
print money for decades and was the No.1 factor behind
the phenomenal return of Fannie Mae stock (NYSE:FNM)
during the 1980s and 1990s.

One would expect Fannie executives to be content with
this business and not "kill the goose that lays the
golden eggs," but a combination of hubris, greed, and
pressure to surpass Wall Street's rising expectations
led to an ill-conceived foray into the "credit-default
swap" (CDS) business. The CDS business involves two
parties - the sellers and the buyers of default risk.
The buyers shoulder mortgage default risk in return for
a future stream of mortgage insurance premiums.

Fannie's involvement in CDS is compounded by the fact
that it also guarantees the value of mortgage-backed
securities. The mortgage-backed security (MBS) is the
vehicle that has enabled the globalisation and
socialisation of US mortgage supply and default risk.

In this default insurance segment of its business,
Fannie cobbles together a pool of mortgages that it
purchases from mortgage brokers. These mortgages bear
similar sizes and risk profiles and are bundled together
to form a security that closely mirrors a bond (but
includes an expected level of default and "prepayment"
risk). This feat of financial engineering enables, for
example, a group of Japanese retirees in Yokohama to
finance the mortgage of a crane operator in Buffalo...or
a teacher in San Diego...an Intel sales executive in
Silicon Valley...and thousands of other Americans.

Thus geographical boundaries and prudent lending
practices at your local bank are no longer limitations
to US mortgage growth. The result has been the hyper
growth of the American mortgage business, bridging the
gap between willing lenders and borrowers aspiring to be
homeowners.

Is this necessarily a bad thing? Not according to Alan
Greenspan and the Wall Street establishment. They argue,
convincingly, that the diversification of mortgage risk
makes global capital markets far more efficient and
minimizes the chance of a major bank having "life-
threatening" exposure to a depressed regional economy.
Indeed, Europe operates a similar model. The UK mortgage
market is also moving into issuing mortgage-backed
securities. And you may recall how overexposure to
mortgage lending in Texas during the 1980s oil bust was
a crucial ingredient in the savings and loan crisis.
Hence mortgage-backed securities are seen as a safety
net.

But praise of this financial engineering ignores and
minimises the self-reinforcing cycle of aggressive
lending practices which lead to higher house prices,
which lead to more aggressive lending, which leads to
even higher house prices.

Once this beast was unleashed, it took on a life of its
own, leading ultimately to the predicament facing
central bankers today: House prices must stay elevated,
and continue to appreciate at rates higher than the CPI
inflation rate, to maintain the illusion among the
public that an "asset-based" economy is sustainable in
the long run.

Two additional factors that the cheerleaders of the
mortgage-backed security market ignore and minimise are
human error in the pricing of risk and moral hazard.
Monte Carlo simulation models and supercomputers cannot
fully distil raw human emotion into neat formulas and
pretty bell curves. Misunderstanding the risks involved
with financing a home purchase on the other side of the
world can lead to an abrupt liquidity crisis when the
momentum behind the housing market stalls, as it has
now.

Enron was humming along nicely, raising enormous amounts
of capital from "efficient markets" - which are commonly
elevated to omniscient status - until the company hit a
liquidity crunch in which lenders declined to continue
financing its giant Ponzi scheme. The important lesson
investors should take away from Enron is not how to
detect an elaborate accounting fraud, but to expect that
greed and fear will overwhelm the "efficient market"
theory when the providers of capital underestimate their
own capacity for error. Human error and the chances of
underpricing default risk should not be underestimated.

The growth of moral hazard is yet another consequence of
"globalising" the mortgage market. The term "moral
hazard" originated with the insurance industry, and
refers to the incentive of the insured party to increase
risky behaviour once it no longer has monetary
responsibility for the consequences of risk.

Applied to the mortgage-backed security phenomenon, one
can think of mortgage brokers as the insured party.
Because they do not retain and service them on their
books, they approve mortgage applications that otherwise
they would reject as excessively risky.

In effect, institutional and international providers of
capital act now as insurance companies that seem unaware
of how risky their agents are acting in underwriting US
mortgages. A disconnect between those who underwrite
mortgages and those who end up holding them will prove
to be a huge problem. This does not really become
obvious until housing market conditions worsen further.

Then we will find out the consequences of hyper growth
in mortgage securitisation.

Regards,

Dan Amoss, CFA
for The Daily Reckoning

P.S: There were probably hundreds of thousands of bad
loans written when the sun was shining on this market
that will only be exposed once the storm clouds fully
gather. This process has only just begun and
delinquencies and defaults will cast a pall over the
industry. Fixed income investors will flee America's
subprime lending market in a hurry...perhaps outside the
US, too...fully pricing in the risks of lending where
the collateral is overinflated and many borrowers have
been less than truthful about income and assets.