Weekly Market Commentary – August 26th, 2008
Prior to starting Epic Advisors, I had worked in Goldman Sachs’ and JPMorgan’s mortgage divisions. To the average investor who has watched the mortgage market ignite a credit storm, the land of mortgages is a scary place that has the ability to create carnage. The toxic brew of subprime loans, overly leveraged derivatives and naïve belief that house prices can only rise has led to large losses, the disappearance of banks and brokerage firms and general confusion. When you consider that most CEOs do not fully understand the risks that reside on their balance sheet, it is easy to see how the average investor looks at the financial sector with apathy and distrust.
Having spent nearly a decade analyzing mortgages, the mystery that surrounds this market is unfounded. At the core, the mortgage market is fairly simple. A bank making a loan has two options. They can either hold the loan in their portfolio and earn income over time or they can sell the loan to a third party, realize a gain and then repeat the cycle. If you sell the loan, the prices set by the market dictate the rate a customer receives. Look to the secondary market, add in hedge costs, a profit margin and then charge the corresponding rate. As long as you are efficient in hedging the loans and running your mortgage origination platform, revenue should be predictable with losses controlled.
If the bank holds the loan, they need to add their funding cost, profit margin and a few other assumptions to derive a rate for the customer. As an example, assume a bank can borrow money at 4%. Further, the bank assumes the combination of future losses, overhead and hedging cost equal 1%. Finally, the bank decides they would like to earn 1.50% on this loan. Add up all the number and the customer should be charged a rate of 6.50%. If a bank can originate at this level, they are writing profitable business that allow for steady returns over time.
So if this market is so simple, how do we find ourselves in the current mess? The blame lies with two distinct groups – those originating loans and the Wall Street firms that securitized them. When originating a loan, focus must always be given to the ability and intent of the borrower to repay the loan. Since the foreclosure process takes time and money, mortgage investors will do all they can to avoid owning property. Typically, you protect against this risk by requiring a large down payment, solid credit and debt payments that are reasonable. As the housing market grew into a bubble, this equation went out the window. Seeing prices rise, investors began to view the risk of foreclosure as small and even when it occurred the losses were non-existent. Since most house prices were rising quickly, a borrower who fell behind on their payments could always sell the house, repay the lender and walk away with cash in their pocket. In those instances when the lender foreclosed, the property was often sold at a profit. This virtuous cycle allowed lender to ignore prudent lending standards and offer loans to anyone who applied. At the same moment, the Wall Street securitization machine projected rising homes prices far into the future, underwrote securities with too much risk and encouraged lenders down this path. As we now know, the results have not been pretty.
As mortgage market competition increased, lenders raced to gain market share. The most difficult thing for any business leader to do is sacrifice market share for profitability. With the benefit of hindsight we know that a truly outstanding CEO would have avoided writing bad loans, ceded market share to his competitors and waited for a market downturn to reclaim share in a more profitable environment. Very few did so. Instead, banks, investment banks and standalone mortgage companies raced to the bottom so they could write the next loan and book the next profit. All believed they were smart enough to unload the poor loans to someone else and only keep the good loans for themselves.
The massive losses realized by firms such as Bank America, Morgan Stanley and Merrill Lynch show how fragile this assumption was. Firms expanded into new lines of business, committed their balance sheet for assets they expected to deliver future profitability and have been saddled with losses. One can look at Merrill Lynch’s decision to expand their risk profile and chide them for their foolishness. After all unless you are a shareholder, you are indifferent to the carnage. However, two firms that expanded into new lines of business and became aggressive buyers of mortgage affect all of us. Those firms are Fannie Mae and Freddie Mac.
Fannie Mae was founded as a government agency in 1938 to provide liquidity to the mortgage market. They would buy loans from banks and allow those banks to issue new loans. The intent was that by creating a secondary market, mortgage rates would decline and lending activity would increase. In 1968, Fannie Mae was converted into a private company and Freddie Mac was created as another private company that would provide competition. Although there was no formal tie to the US Government, investors have always viewed the two companies as quasi-government agencies that would be supported if they experienced hard times.
Over time, Fannie and Freddie expanded and became dominant forces. The belief that the government would support them led to very low borrowing costs. As mentioned above, a mortgage investor’s borrowing cost is among the key variables that determine what interest rate should be charged. Since Fannie and Freddie borrowed cheaply, mortgage rates were kept low and housing more affordable. Since neither agency experienced material losses on either the mortgages they guaranteed or the loans held in portfolio, business looked great. Had they stuck to their core mission of buying conforming loans that were relatively small in size, underwritten properly and had reasonable down payments, disaster would be avoided. Unfortunately, management at each firm was unable to resist temptation and dove into new lines of business with risks that were not fully appreciated.
As Fannie and Freddie began buying Alt-A and subprime loans, their risk profile increased. These loans were not the rock solid investment upon which each firm had focused over the prior decades. Instead, they were poor loans who would only turn profitable if home prices continued appreciating and credit losses avoided. Fannie and Freddie convinced themselves that their horde of PhDs and computer models could create risk based pricing where they were paid for making poor loans. Unfortunately, their models did not fully account for falling home prices.
To further complicate matters, Fannie and Freddie operated under guidelines no other financial firm could follow. Leverage was excessive and filings with the SEC were not timely. Investors had little information about the true financial condition of the firms. Even when each management was caught in accounting scandals, political connections allowed for mild punishment. Simply, a highly leveraged investor with poor assumptions and inadequate risk management was running amuck in an industry that supported the housing market and all the economic growth that accompanies it.
For anyone who follows a free market ideology, the chaos at Fannie and Freddie should be comforting. It proves that the markets will eventually correct for imbalances and punish those following an imprudent strategy. Day traders flipping tech stocks on margin during the dot-com bust learned this lesson. Investors flipping condos during the housing bust learned this lesson. Over-leveraged hedge funds with great quantitative models learned this lesson. Should not Fannie and Freddie learn this lesson? Should not the US Treasury seize control of each firm, wipe out shareholders and restore discipline to the mortgage market? The simple answer is Treasury should. Whether or not they will is a much more complicated question.
Complicated? How can that be? Simply shut down the firms and move on. Again, it is not that simple. There are three main issues that prevent a quick takeover by Treasury. They are the effect on mortgage rates, the effect on the banking sector and the lattice work of integration issues that would accompany such a move.
When you consider that Fannie and Freddie have purchased the majority of loans originated this year, their absence from the market would siphon off a large source of demand. Currently, loans that are not sold to the agencies carry an interest rate that is 1.50% higher than loans that Fannie and Freddie buy. It is reasonable to assume that the agencies downscaling their position in the mortgage market would immediately result in higher mortgage rates. These higher rates would further stress the housing market and prevent an economic recovery.
If Treasury wipes out the shareholders as many have recommended, the damage to the banking sector will be immense. Nearly all of the agencies’ preferred stock is held by banks and insurance companies. In the past few days, we have seen JPMorgan, Sovereign Bancorp and other regional banks announce losses related to these securities. While one could argue these banks should be punished for a risky investment, the line of argument is pointless. Simply, banks are already suffering massive losses from their loan portfolios. Many have sought outside equity and are struggling to write new business. Unless lending increases, economic growth will not resume and the recession will worsen. The last thing Treasury needs to do is add to the problems banks are facing and increase the economic hardship.
The final issue concerns the complexity of each firm. If Treasury were to seize control, one could argue that two firms are not necessary. By combining the entities, Treasury could cut costs, improve efficiency and create a more nimble firm that would provide benefits to the mortgage market. This sounds nice in theory, but how do you go about the merger? Freddie and Fannie have different systems, different cultures and securities that are similar yet very different. Picking one operating environment over another while under control of the US Treasury would be a chaotic experience filled with political meddling. Even the best bank managers would have difficulty merging these two firms. To assume the merger could be integrated in four months before this administration leaves in unrealistic. Further, to assume either political party has the stomach to tackle such complex issues in a heated election year may be giving our elected officials more credit than they deserve.
Given the poor outlook for the firms and the combination of integration issues, what is the most likely outcome? In this environment, one can never know for certain. While I agree that Fannie and Freddie are overleveraged, overly bureaucratic and have poor risk management, the complexity and political issues surrounding a Treasury infusion that wipes out shareholders are overwhelming. Instead, a pattern of financial support from the Federal Reserve (Fed), backing from Treasury and patience seem most likely. After all, the Fed has shown in the past that it is willing to allow struggling banks with capital issues to patiently fix their problems and slowly earn their way out of current problems. Currently, the Fed has created a steep yield and funding support to allow banks to earn high spreads on new loans. With little competition, Fannie and Freddie have been writing profitable business today in order to correct for past mistakes. Will regulators give Fannie and Freddie the same patience that has been accorded to Wells Fargo and Washington Mutual? We can never know for sure, but reasonable people could assume so.
With such a murky view, what should an investor do? The daily pattern of trading in Fannie Mae and Freddie Mac shares has been violent with wide swings in each direction. Over the past week, the shares often move 20% intraday. These swings provide opportunities and risks. An astute trader can flip back and forth and book large gains. However, slight missteps can lead to large losses. Currently I have small positions in each. Not knowing what the ultimate outcome will be, I will constantly look to reduce my risk via the option market and book gains as soon as they become available. If we have learned anything during the past year, it is that surprises constantly occur and there is always another shoe to fall.
You are the man Sean! Thanks for my weekly update!!!