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Welcome To The Mortgage Business
By Chris Ciovacco
Ciovacco Capital Management
September 6, 2008
NOTE: This first portion of this article was written
after Sunday's detailed Fed announcement.
The text below is taken directly from the government’s
announcement.
The Good News For Taxpayers:
"With this agreement, Treasury receives senior preferred
equity shares and warrants that protect taxpayers. Additionally, under the
terms of the agreement, common and preferred shareholders bear losses ahead of
the new government senior preferred shares."
"While conservatorship does not eliminate the common stock, it
does place common shareholders last in terms of claims on the assets of the
enterprise."
"Similarly, conservatorship does not eliminate the outstanding
preferred stock, but does place preferred shareholders second, after the
common shareholders, in absorbing losses."
The Bad News For Taxpayers:
“To promote stability in the secondary mortgage market and
lower the cost of funding, the GSEs will modestly increase their MBS
portfolios through the end of 2009. Then, to address systemic risk, in 2010
their portfolios will begin to be gradually reduced at the rate of 10 percent
per year, largely through natural run off, eventually stabilizing at a lower,
less risky size.”
"Treasury will ensure that each company maintains a positive
net worth."
“The second step Treasury is taking today is the establishment
of a new secured lending credit facility which will be available to Fannie
Mae, Freddie Mac, and the Federal Home Loan Banks.”
“Finally, to further support the availability of mortgage
financing for millions of Americans, Treasury is initiating a temporary
program to purchase GSE MBS.”
The Spin For The Public:
"Preferred stock investors should recognize that the GSEs are
unlike any other financial institutions and consequently GSE preferred stocks
are not a good proxy for financial institution preferred stock more broadly.
By stabilizing the GSEs so they can better perform their mission, today's
action should accelerate stabilization in the housing market, ultimately
benefiting financial institutions. The broader market for preferred stock
issuance should continue to remain available for well-capitalized
institutions.”
“Nothing about our actions today in any way reflects a changed
view of the housing correction or of the strength of other U.S. financial
institutions.”
NOTE: The portion of the article below was written on
Saturday before Sunday's detailed Fed announcement.
Welcome To The Mortgage Business
As a U.S. taxpayer and private citizen, I never intended to
enter the mortgage business. According to reports published after the markets
closed on Friday, all U.S. taxpayers will soon be active participants and
financial stakeholders in the U.S. mortgage market. When a homeowner decides to
“walk away” from their mortgage obligation or cannot make the payments for any
reason, you and I, without our consent, will be obligated to help.
What Are We On The Hook For?
Fannie Mae and Freddie Mac buy mortgages from mortgage
originators. They pool the mortgages and sell an interest in the mortgage pool
in the form of bonds. The principal and interest payments from the homeowners
pass-through to bondholders in the form of a payment. If some of the mortgage
holders default or simply walk away, Fannie and Freddie guarantee principal and
interest payments to the bondholders. In the very near future, you and I as
taxpayers will guarantee the principal and interest payments to the bondholders.
You and I will stand behind what the New York Times referred to as “huge
potential liabilities” which could cost the taxpayers “tens of billions of
dollars”. Welcome to the mortgage business.
Fannie & Freddie Part Of The Problem: Guarantees Encourage Lax
Lending Standards
Mortgages carry risk. If you place a guarantee behind a
mortgage-backed security, like Fannie and Freddie bonds, there really is no risk
to the investors who keep supplying capital to the mortgage market. As investors
supply more capital to the system, more questionable mortgages can be written
and builders can keep building more houses. Why is anyone guaranteeing
mortgages? Placing a guarantee behind a risk asset creates moral hazards. Why?
Because the loan originators do not care if the mortgage holder keeps making
their payments since they can sell the mortgage to Fannie and Freddie, who in
turn will place a guarantee behind the mortgage. The guarantee behind Freddie
and Fannie bonds were and will continue to be a source of moral hazard. If you
remove the guarantee and Fannie and Freddie from the entire system, banks and
investors would treat mortgages as risk assets, which is what they are. Instead
of propping up Fannie and Freddie with taxpayer funds and guarantees, both firms
should be gradually removed from the system. The free market can supply mortgage
capital to people who have the necessary debt-to-income ratios and credit
history. Loans should be made to people who can pay them back. The current state
of the mortgage and housing markets clearly illustrates the results of placing
guarantees behind risk assets, which is what Fannie and Freddie do. Fannie and
Freddie are part of the problem, not part of a solution. Selling a house to
someone who cannot make the payments is not helping anyone and is not part of
the American Dream.
Government Cannot Keep Spending Money It Does Not Have
If you are worried about the sustainability of Medicare and
Social Security, this announcement will not help you sleep at night. Our
government is rapidly moving down an unsustainable path. The longer we continue
to plug holes with more taxpayer commitments, the harder the eventual and
inevitable fall will be. We are moving closer and closer to the United States
losing its AAA credit rating. The decisions being made today have serious
long-term economic consequences. The most recent bailout is “good news” in the
short-run and for the short-sighted, but bad news in the long-run for all
Americans. This bailout significantly damages our country’s long-term financial
outlook.
"Treasury Secretary Hank Paulson swatted back reports of
government nationalization of Fannie and Freddie, which would mean making
explicit what, has long been an implicit taxpayer guarantee of their
liabilities. This would instantly add $5 trillion in liabilities to the
federal balance sheet, doubling the U.S. public debt burden and putting
America’s AAA credit rating at risk. This is a nightmare scenario for
taxpayers."
Wall Street Journal, Saturday, July 12, 2008
Changing the Rules In "Free" Markets Over The Weekend
As stocks for no apparent reason found some support late on
Friday afternoon, I repeatedly searched Google News right up until the close on
Friday. For those of you who do not use Google News, it enables you to search
thousands of news outlets for stories on any topic. It is a great way to make
sure you are not missing something which may affect asset prices. Before the
markets closed on Friday, I searched for Fannie and Freddie, but found nothing,
not even a rumor of any government intervention or possible capital injections.
I chalked Friday’s somewhat unusual strength in financial stocks up to the
persistent rumors that Lehman Brothers (an investment bank/brokerage) was close
to making an announcement to help stop the bleeding on their balance sheet.
After Hours and Weekend Bailouts Leave No Opportunity for
Action
The first reports of the impending government bailout came
around 4:40 pm ET on Friday; forty minutes after the markets had closed. The
initial reaction to the news from the financial markets on Monday will no doubt
be positive. Treasury Secretary Henry Paulson sold his plan for Fannie and
Freddie to Congress saying he had no plans to use the authority. In recent
weeks, Treasury spokespersons reiterated there was no plan to take any action.
The law giving Paulson the authority to intervene was signed by President Bush
only five weeks ago. The last public comments by Paulson were made on August
10th when he reiterated he had “no plans” to use his authority. As a taxpayer
and investor, I question Mr. Paulson’s credibility given the recent public
statements and this weekend’s news. What has changed so dramatically since
August 10th to warrant a bailout over a weekend? It is nearly impossible to
believe plans were not being made behind the scenes for what now appears to be a
full bailout at the taxpayer’s expense. Yet, we were told by our trusted public
servants that no action was imminent. I thought transparency was part of a free
market system.
Those of us close to the financial markets knew it was only a
matter of time before this announcement would be made, which does not mean we
agree with it. The announcement is not a surprise, it is the fact that Feds went
from “no plans” for intervention to Congressman Barney Frank admitting this
Saturday that intervention will take place. Based on recent government
intervention (Bear Stearns and the Fannie/Freddie July announcement) , it
appeared very likely the Feds would wait until Fannie and Freddie’s stock came
under extreme duress or until a new issue of Fannie or Freddie bonds received a
very poor bid from the market. Once the situation turned bleak, a transitory
statement from the Treasury stating ‘we are exploring all options’ would have
given participants in the free market some time to prepare. Instead, the Feds
acted in the absence of an immediate crisis, no transitional statements from the
Treasury, no warning…. just another weekend surprise. It is disturbing that we
have now reached the stage where the government is intervening in the free
markets before there is a crisis to provide cover for their actions. Policy
makers must assume government participation in the free markets is now an
accepted practice. They no longer try to pretend their intervention is warranted
due to an immediate crisis which leaves them 'no choice' but to act.
The Markets May React Positively, But the News and Long-Term
Outlook Is Not Good
The bailout is being announced now because the policy makers
know a bottom in the housing market is not imminent. If there was even a remote
possibility of an impending turn in housing, do you really think a Republican
administration is going to announce the bailout of public companies two months
before a Presidential election? This bailout sends a clear message that things
are bad and they are likely to get worse before they get better.
This bailout tells us that more foreclosures are coming, which
means more problems lie ahead for banks and brokerage firms. This announcement
will help moderately improve the availability of mortgage credit, but it does
not directly address the core economic issue of supply and demand in the housing
market. Short of the government bulldozing homes, it is going to take more time
to work off the inflated inventory of homes. At this point, I’m sure the
government would be happy to state it has “no plans” to bulldoze homes. As long
as the supply of homes remains high, prices will continue to fall. Based on
history, we can expect some hope when the inventory of unsold homes falls to a 6
to 7 month supply. We currently have a 10 to 11 month supply of unsold homes. It
does not take a Harvard MBA to figure out prices have further to fall in most
markets around the country.
Even if sales increase, sales at lower prices mean continued
deterioration of the value of assets held on bank balance sheets. As a result,
banks will continue to be in need of capital injections. More write-offs are
coming. Banks will remain reluctant to extend credit. Tight lending standards
are not good for an economy which is highly dependent on credit. Tight lending
standards mean fewer buyers for all goods and services. Fewer buyers lead to a
weaker economy. A weaker economy leads to more job losses. Job losses lead to
more mortgage defaults….and around and around we go until the supply of homes is
reduced to a reasonable level.
The government’s bailout of Fannie and Freddie does not make
things much better, but it does prevent them from getting worse in terms of
further constraints on Fannie’s and Freddie’s ability to support the mortgage
market. My guess is Wall Street will once again declare this signals the end of
the financial crisis, just as they did after the Bear Sterns bailout and the
first Fannie and Freddie announcements in July. While this is truly distressing
news for taxpayers and the long-term outlook for the dollar, it is good news for
the financial markets in the short-run since it will remove one layer of
uncertainty. However, it is a stretch to believe this most recent unprecedented
move by our government will mark an end to the credit crisis. A good way to sum
up this situation is that this announcement is good news for traders and bad
news for longer-term investors and taxpayers. While we can expect Wall Street’s
positive spin on the big picture next week, the real big picture is housing
prices have further to fall, banks still face serious problems, and the
financial stability of the U.S. government continues to deteriorate.
The Markets Are Running Out Of Things To Look Forward To Down
The Road
Financial markets are always looking forward, albeit only about
three weeks in the current trading-oriented markets. The markets have looked
forward to Fed rate cuts and government bailouts since the credit crisis began.
Now that the Fannie and Freddie news is out, I’m not sure what the markets have
to look forward to.
How Does This Affect Our Current Investments?
This article was written on Saturday before the formal details
of the Feds plans were announced. Therefore, it is difficult to speculate on the
market’s reaction. This news could spark a rally in stocks which lasts several
weeks. In the short run, defensive positions will most likely come under
pressure and more speculative positions will benefit. In the long run, I’m not
sure too much has changed. We’ll continue to closely monitor the situation over
the next few days.
Chris Ciovacco
Ciovacco Capital Management
Chris Ciovacco is the Chief Investment Officer for Ciovacco
Capital Management, LLC. More on the web at
www.ciovaccocapital.com
All material presented herein is believed to be
reliable but we cannot attest to its accuracy. The information contained herein
(including historical prices or values) has been obtained from sources that
Ciovacco Capital Management (CCM) considers to be reliable; however, CCM makes
any representation as to, or accepts any responsibility or liability for, the
accuracy or completeness of the information contained herein or any decision
made or action taken by you or any third party in reliance upon the data. Some
results are derived using historical estimations from available data. Investment
recommendations may change and readers are urged to check with tax advisors
before making any investment decisions. Opinions expressed in these reports may
change without prior notice. This memorandum is based on information available
to the public. No representation is made that it is accurate or complete. This
memorandum is not an offer to buy or sell or a solicitation of an offer to buy
or sell the securities mentioned. The investments discussed or recommended in
this report may be unsuitable for investors depending on their specific
investment objectives and financial position. Past performance is not
necessarily a guide to future performance. The price or value of the investments
to which this report relates, either directly or indirectly, may fall or rise
against the interest of investors. All prices and yields contained in this
report are subject to change without notice. This information is based on
hypothetical assumptions and is intended for illustrative purposes only. PAST
PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS.
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