Agora Financial’s Rude Awakening

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Laguna Beach, California

• Goodbye Fannie and fare thee well Freddie
• America’s largest mortgage lenders become penny stocks,
• From “dubious justifications to indirect taxations” and more…

Eric Fry, reporting from Laguna Beach, California…

Goodbye Fannie, Farewell Freddie…We will miss you both.

We will miss the epic housing bubble you nurtured; the wealth delusion you fostered; and the arrogance you epitomized. Above all, we will miss the hope you inspired in the breasts of so many Americans – the hope that a “free lunch” did, in fact, exist and that impossible was, in fact, possible.

For the last several years, these two mortgage-lending giants performed a kind of financial high-wire act – piling up multi-trillion dollar liabilities with the greatest of ease. The high-wire act itself, was terrifying, but not nearly as terrifying as the public’s indifference to it. Almost no one seemed to worry that the acrobatic lenders might slip from their perilously leveraged balance sheets.

“What happens if they fall?” your anxious editor would sometimes ask the onlookers. “They won’t” came the ambivalent response. “Besides, the federal government is holding the net.”

“But those two tightrope walkers are carrying much more weight than the high wire can possibly support!” we insisted.

“Well they haven’t fallen yet,” came the practiced reply, “And besides. The wire is much stronger that it looks. It is a high-strength composite of single-family mortgages, reinforced by state-of-the-art derivatives.”

“Okay,” we would shrug. “But just the same, I think I’ll watch the rest of the performance from a safe distance…just in case.”

The high-wire finally gave way yesterday, and the share prices of Fannie Mae and Freddie Mae plummeted into a grotesque heap. Fannie Mae (NYSE: FNM) tumbled $6.31 to a mere 77 cents per share, while Freddie (NYSE: FRE) dropped $4.22 to 88 cents a share. America’s largest mortgage lenders are now penny stocks.

Your editor had feared this day for many years, and had aired his concerns on numerous occasions. During an October 2004 speech in New Orleans, for example, your editor warned the attendees that Fannie and Freddie were both carrying life-threatening quantities of leverage. To emphasize the point, he produced the photo below.

He did not actually believe that Fannie and Freddie would perish, but neither did he hold out hope for a long and happy life. Your editor had always feared the worst for these two stock market darlings, not because his possessed any extraordinary insight, but because he possessed an utterly ordinary – almost pedestrian – fear of leverage. In particular, he feared the sort of extreme, impossible-to-an analyze, leverage that became the hallmarks of these two government-coddled mortgage lenders.

The demise of Fannie and Freddie has destroyed hundreds of billions of dollars of investor wealth. And this saga’s destructive legacy may continue for several more years. Sadly, it’s impossible to undo the damage. But it’s not too late to learn from it.

The range of possible lessons is vast, but one very essential lesson springs to mind immediately: “Ignorance equals risk.” Or, as Warren Buffet famously remarked, “Risk comes from not knowing what you’re doing.”

To illustrate this critical investment lesson, we’ve dusted off an ancient issue of the Daily Reckoning entitled, “Disrobing Fannie Mae.” In this column, which appeared July 9, 2003, your editor wrote: “My observations cause me neither to like nor dislike [Fannie Mae'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,” your editor continued, “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 yet, somehow, this behemoth produces perfectly smooth, consistent earnings growth year after year. How does this happen?…” (Click on this link to read the rest of this column)

The world now knows the answer: It does not happen. Fannie and Freddie did not perform the impossible, they performed the ridiculous, bordering on the fraudulent.

We’ve seen this trick many times before, but never on such a grand scale. The trick always begins the same way and ends the same way. It begins with leveraged balance sheets and nonsensical accounting. It ends with smoldering ashes of market capitalization.

Large scale government bailouts also follow a predictable pattern. They begin with dubious justifications and end with indirect taxations…like soaring interest rates and inflation. In the column below, Chris Mayer, editor of Mayer’s Special Situations, provides an historical perspective of governmental meddling…

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The “Argentinization” of America
By Chris Mayer

Every morning, I descend on my bevy of newspapers, which I cheerfully digest over a hot mug of tea. Yesterday, the headlines of all the newspapers carried the same story: the U.S. government’s takeover of mortgage giants Fannie Mae and Freddie Mac.

Does this really promise big change in the course of U.S. financial markets?Both companies trade on the New York Stock Exchange. So both companies supposedly belong to shareholders. But Fannie and Freddie were never really private companies. Congress created the mortgage giants by charter (hence, they are called government-sponsored enterprises, or GSEs). Therefore, Fannie and Freddie have long operated in a sort of limbo as a result, neither fish nor fowl. Both carry the implicit guarantee that if something went truly wrong, the government would come along and make it right.

And so it has. Bondholders are happy today. Stockholders are not. Fannie Mae dropped 90% yesterday. Freddie Mac tumbled 83%. I have no flag in either camp, but I certainly have no sympathy for the stockholders. Anyone who gave them a fair look could see that both GSEs were ticking time bombs.

In fact, I wrote an essay for the Mises Institute titled “Mortgage Market Socialism” way back in 2002. I pointed out the dangers of the growth of these GSEs far outpacing that of the mortgage market. If I may quote: “The longer the GSEs are able to expand as they have, the more certain it becomes that someday taxpayers will have to bear the cost of such excess.”

This is one of those times when I am not happy to have gotten it right. Taxpayers — of which I am one — will now pay for these mistakes. Yet despite all of the hubbub in the papers, this is nothing new.

This action by the U.S. government does not really signify any sea change in financial markets. It’s just another step in a long journey on the same path. If you read financial history, you come to appreciate this overwhelmingly powerful trend. As Freeman Tilden wrote in his 1935 book A World in Debt:

“The whole progress of the legislative attitude toward the debtor, from the Roman Republic to the present day, has been steadily, though with occasional backward lapses, toward making debt easier to incur, lightening the burden of carrying and softening the consequences of default.”

The fancy modern words for this process are the “democratization of credit” and the “socialization of risk.” Another excellent historical study of this process is James Grant’s Money of the Mind: Borrowing and Lending in America From the Civil War to Michael Milken. It is beautifully written, for one thing. And it will show you this process has been going on for a long, long time.

I don’t usually comment much about big picture events. But the bailout of Fannie and Freddie deserves some sort of comment — mainly because I fear that yesterday’s bailout speeds the United States down a perilous path.I fear that we might be going the way of Argentina. One day, we’ll have some major Argentine-style financial crisis. We’ll have Argentine inflation and a similar loss of faith in the banking system and the currency. The government will chew away and destroy a lot of wealth in the process.

Hopefully, I won’t quote myself on that someday soon. In the meantime, though, I think one of the best things an investor can do is focus on buying useful and tangible assets that ought to hold their value against a depreciating paper currency. These assets include oil and gas, metals and minerals and land and water rights. The shares of the companies that own or find these assets ought to do well. Commodities will have their day in the sun once again.

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[Rude Endnote: Meanwhile, back in the land plenty – dollars, debts, donuts – the market reacted positively to the death of Fannie and Freddie yesterday. The Dow shot up almost 300 points after Asian and European markets led a global charge.

European stocks are still rallying through today. London’s measure is among the best of them early on, perhaps trying to make up for lost trade after yesterday’s technical glitch. The FTSE is up 1.4% while Germany and France’s markets are up just under 1% each.

The tigers have backed off a little though. The Nikkei 225 is down about 1.8% as we write while the Hang Seng is off about 1.5%. The reason? After Uncle Sam dumped $5.3 TRILLION into its liabilities column, the dollar rallied. Go figure.

Until tomorrow…

Cheers,

Joel Bowman
Rude Awakening

aussiejoel@the-rude-awakening.com