Disrobing Fannie Mae / The Daily Reckoning

verfasst von - Elli -, 09.07.2003, 21:13

-->Disrobing Fannie Mae

The Daily Reckoning

Paris, France

Wednesday, 9 July 2003

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*** Tech stocks still rising...

*** Walmart - China's 8th largest trading partner...

*** Gold falls...True Believers...communists...and more!

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Tech stocks led the charge of the light-headed brigade
again yesterday. Internets, for example, went 1.8% deeper
into the Valley of Death, as Ebay approached its all-time
high.

They are not likely to get out alive, is our guess.

All great bear markets are accompanied by great bear market
rallies. This one won't be any different. Which is not to
say the rally can't go on for a long time and make a lot of
people think they are getting rich.

But that is the idea, after all - that's what makes it a
great bear market; it takes a great many investors down
with it.

Eric is still at the beach. Addison is on his way to the
hospital again this morning, following yesterday's false
alarm. They have left your editor alone at the helm of the
Daily Reckoning. Is that a sand bank he sees? Or is it a
fog bank? Or a Federal Reserve bank? Damn the
torpedoes...full speed ahead!

And so we push on...dear reader...into the Great Unknown...

And who is that hiding in the bushes? Why, it's Mr. Bear!
Of course, can't come out and scare everyone right away.
He's got to let them think it is safe...that there is
nothing to worry about. So, he mauls a few investors and
then retreats. The others think he's gone away for good.

"It's okay...," they tell each other."The long-term bull
market is still in business. Don't be wimps...c'mon, let's
have fun..."

That 'good time' attitude can take a lot of wear and tear
before it finally gives way. We are 40 months into the
Great Bear Market, and still investors believe in the
eternal bull market on Wall Street. They shifted from
stocks to bonds...and now seem to be shifting back to
stocks (who wants to miss the next bull market!). But the
belief in The System - in Wall Street...in American
capitalism...in the Federal Reserve and the dollar...in the
democratic government...in Social Security...unemployment
compensation...in mortgage refinancing...and in all the
institutions of the great social welfare state of the late
Dollar Standard period - remains intact.

How can it be, we ask ourselves? How can people still be
not only believers, but True Believers, with more faith in
the American System than Russian Marxists ever had in
communism?

One answer is simple. While we are 40 months into the
correction, the boom that preceded it developed over the
course of an entire generation and shaped its habits. The
Dollar Standard came into being when Richard Nixon
eliminated gold from the international monetary system in
the early '70s. Henceforth, central banks would measure
their reserves in dollars, not in gold. And henceforth,
Americans were able to print as many dollars as they
wanted, without worrying about whether they had the gold to
back them up.

There is probably no one more spendthrift than the man who
can print money in his own garage. By Year 15 of the Dollar
Standard period, Americans had spent so much that the
nation slipped below the water line of debt, having been
the world's largest creditor a few years before. By year
30, it had sunk so deep it was the world's largest
debtor...and the largest debtor the world had ever seen.

Yesterday's news brought word that the U.S. had achieved
yet another record. Its trade with China produced the
largest deficit between two countries the world has ever
seen. Walmart alone bought so much stuff from China that it
would be China's 8th largest trading partner, ahead of
Britain and Russia, if it were a sovereign nation. And the
gap continues to widen!

Automotive News:"The shift to Chinese production
eventually will cost hundreds of thousands of manufacturing
jobs in the United States. And it will put more pressure on
smaller, cash-strapped suppliers to make a risky investment
on a distant continent.

"Both Ford and GM are offering a two-continent deal. If a
supplier builds a factory in China, it can sell parts to a
Ford or GM assembly plant in China, then export parts to
the automaker's North American assembly plants. Those deals
are starting to add up. According to the U.S. Department of
Commerce, total imports of Chinese auto components totaled
$2.2 billion last year, nearly triple the volume of imports
in 1997.

"China will dwarf the impact Mexico has had on the U.S.
auto industry, says Detroit economist David Littmann. From
the perspective of North America's purchasing managers,
Littmann says,"China is vastly more encouraging than
Mexico.

"For automakers, China looks like a bargain. For suppliers,
that price can be steep. In the years to come, segments of
the U.S. supplier industry may migrate to Asia. For
example, U.S. mold and die makers already have lost an
estimated 6,000 jobs to Chinese rivals in recent years."

Russian communists were undone by the very materialism they
adored. Everywhere they looked, outside their own country,
people were getting rich from market-based economies. Their
socialist system could not keep up. So, they abandoned the
race altogether.

Now, it is our turn. The True Believers seem not to notice,
but socialism took root in America as well as Russia.
Retirements were socialized by the Social Security program.
Unemployment compensation, EEOC, OSHA, and welfare programs
socialize the job market. Wealth itself is socialized by
means of a progressive income tax and various
redistribution programs. There is little left in American
life that isn't socialized, regulated, controlled, bullied,
or menaced in some way by government. Freedom in the modern
homeland is, as the songwriter puts it,"ah...that's just
some people talking."

Why would Americans put up with it? Why would they give up
their freedom without a fight...and now support The System
more than ever before...in the name of"liberty?"

We came across this passage in a book by Gerard Maudrux:

"Bismarck created the first general welfare system in 1889.
Why? Out of a sense of charity, philanthropy or civic
spirit? No. This brilliant and ambitious politician had
found a good way to make the subjects of his empire docile.
His reasoning was simple: when the citizens all depend on
the state, they won't try to overthrow it or destabilize
it, and they will easily give up their fundamental
liberties. The State will then become stable and
eternal...as long as the system doesn't fail, which is why
you have to maintain it at all costs."

But now, globalized markets are making it hard for
socialized America to compete. The system struggles
forward, but cannot seem to make much headway. Hundreds of
billions of new dollars are printed, but the U.S. economy
barely grows. Interest rates are cut 13 times, and jobs at
home are still lost. Meanwhile, the Chinese...with neither
the shackles of tort lawyers or Medicare, nor the ball and
chain of debt or neo-cons...can produce almost anything we
can - but faster, and cheaper.

And Mr. Bear hides in the bushes.

[Ed note: what has become of our fabled"land of liberty"?
For the beginnings of an answer, see:

The Idea of America
http://www.agora-inc.com/reports/901SIOAB/Ideas/ ]

*** The price of gold fell another $4 an ounce. Strange. In
a world in which inflation is supposedly on the increase,
the main benchmark of it is falling. But if all the
contradictions were removed from today's financial world -
there would be nothing left.

*** Yesterday, at lunch, your editor had an unexpected
pleasure. A young woman came and sat down in his lap.

"Hey, big spender," she began to sing, suggestively
wiggling around.

Later, after the performance was over, she passed the hat,
into which your big-spending editor tossed a euro coin.

"Is this a profitable line of work?" he wanted to know.

"It's a living," came the answer.


Bill Bonner

P.S. Eric Fry checks in from the beach, below...

----------------------

The Daily Reckoning PRESENTS: A fearsome pair of
enterprises. Eric Fry delves deep into the great American
GSEs, below...


DISROBING FANNIE MAE
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 refinancement hypothecaire.
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 will be forthcoming.
However, I will happily provide a series of skeptical
observations about Fannie, the widely adored mortgage
lender. To preview: My observations cause me neither to
like nor 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 it
is difficult to fear it. Fannie Mae is like a great-
tasting, non-fat dessert, 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.
What should we think about a mortgage-finance company that
produces consistent, non-volatile earnings growth,
alongside 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 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. Tracy has 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. If so, the bull market in 'managed
earnings' is also winding down. Which means that the
premium valuations achieved by the masters of managed
earnings - i.e., entities 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 '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 derivatives 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 in
consumers' pockets, and that pace has accelerated this
year, thereby offsetting a severe 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 of these two companies would have serious and
worrisome implications for their share prices, the housing
market, the bond market, the U.S. dollar and the U.S.
economy in general?"What a mortal can easily see," says
Jim Grant, writing in 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.'"


Regards,

Eric Fry,
The Daily Reckoning

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• Disrobing Fannie Mae / The Daily Reckoning - - Elli -, 09.07.2003, 21:13