Our perspective on the current Fannie Mae and Freddie Mac debacle is a portfolio manager's perspective: do not commit capital to companies whose business is deeply entwined with the government*.
It is hard enough to predict the business performance of a company even when it isn't subject to the whims of elected officials.
Beyond that simple dictum, Fannie and Freddie have raised several red flags over the past several years which would be enough to disqualify them from inclusion in a portfolio of well-run businesses.
For starters, both companies were found in 2004 to have manipulated their earnings (as reported by their oversight agency, OFHEO, the Office of Federal Housing Enterprise Oversight). Their management team and boards of directors are often packed with political appointees rather than savvy businessmen and women who have spent their careers gaining experience in fields related to the business of mortgages and securitization. Further, until 2003 these companies didn't even publish regular SEC filings the way every other publicly-traded company was required to do.
Any one of the above problems would be enough to disqualify them from being considered "well-run businesses positioned in front of fertile fields of growth" (a formula we have discussed in several previous blog posts, such as this one).
But, many investors do own securities issued by Fannie and Freddie, such as their public stock, their mortgage-backed debt securities, or their own debt (often called "agency bonds" or "agencies"). One reason their stock was attractive to many investors is the fact that, as "government-sponsored enterprises," they could borrow at lower rates than other private corporations in order to buy mortgages for their own portfolio or to sell to other investors. They used this ability to borrow cheap in order to leverage themselves above 30 to 1 (some analysis suggests as high as 60 to 1).
With all that leverage, they built huge portfolios for themselves: $727 billion for Fannie and $712 billion for Freddie as of 2008 (see this excellent opinion piece from economist Larry Kudlow published yesterday). These portfolios have been extremely lucrative for their employees and their shareholders. Although any private company or individual who leverages himself to such an extent in order to try to make money risks bankruptcy if the investments go awry, Fannie and Freddie have always operated with an "implicit" understanding that the government would stand behind them in a crisis, which is exactly what happened on Sunday afternoon when Treasury Secretary Paulson made that backing explicit.
While we might wisely choose not to invest in entities with so many red flags, as U.S. taxpayers it turns out that we don't have a choice. Thus, as portfolio managers, we must also be concerned about the impact these entities can have on the entire financial system and the economy.
All taxpayers are liable for sharing the losses of Fannie and Freddie, even if they didn't have the opportunity to share in their gains. This is what is called "privatizing the gains and socializing the losses," and it is a situation that the opinion staff of the Wall Street Journal has been vociferously warning against since 2002, in a series of articles available from this Journal page (wittiest title: "Speaking Truth to Fannie" from March 12, 2003).
To the extent that the Fed holds off on raising interest rates in order to ease pressure on these two troubled behemoths, the damage to the purchasing power of everyone's dollar due to inflation hits everyone. The giant capital infusions to Fannie and Freddie offered in Sunday's Treasury announcement would also have an inflationary effect and further rob citizens of the purchasing power in their currency.
The situation with Fannie and Freddie shows the wages of socializing: because the government stood behind them (with your money), Fannie and Freddie took risks that they never could have taken if they had been regular private companies without the safety net of taxpayer dollars, and borrowed money at a price they never could have gotten without that same safety net.
Some defenders of this socialization of Fannie and Freddie say that it is necessary in order to help more people buy homes than would otherwise be able to do so. However, economist Wayne Passmore of the Board of Governors of the Federal Reserve argues otherwise, according to research he did of the actual numbers involved, in this report published in December of 2003. Similarly, we argued in our latest quarterly commentary that these attempts at "social engineering," such as the Community Reinvestment Act, only serve to create inefficiencies, and ultimately hurt those they were intended to help.
In the 2003 report, Dr. Passmore states: "The GSEs' implicit subsidy does not appear to have substantially increased homeownership or homebuilding because the estimated effect of the GSEs on mortgage rates is small." He goes on to say, "My calculation also suggests that roughly 42 percent to 81 percent of the GSEs' market value is due to their implicit government subsidy."
This same pattern is common whenever government interference removes penalties for irresponsible behavior: greater risks will be taken in pursuit of profits, and the intended benefits from the government intervention will turn out to be minor or nonexistent. In the end, the taxpayers will have to pay the wages of socializing, whether they saw the red flags and warning signs, or not.
* The principals of Taylor Frigon Capital Management do not own shares in Fannie Mae (FNM) or Freddie Mac (FRE).It is hard enough to predict the business performance of a company even when it isn't subject to the whims of elected officials.
Beyond that simple dictum, Fannie and Freddie have raised several red flags over the past several years which would be enough to disqualify them from inclusion in a portfolio of well-run businesses.
For starters, both companies were found in 2004 to have manipulated their earnings (as reported by their oversight agency, OFHEO, the Office of Federal Housing Enterprise Oversight). Their management team and boards of directors are often packed with political appointees rather than savvy businessmen and women who have spent their careers gaining experience in fields related to the business of mortgages and securitization. Further, until 2003 these companies didn't even publish regular SEC filings the way every other publicly-traded company was required to do.
Any one of the above problems would be enough to disqualify them from being considered "well-run businesses positioned in front of fertile fields of growth" (a formula we have discussed in several previous blog posts, such as this one).
But, many investors do own securities issued by Fannie and Freddie, such as their public stock, their mortgage-backed debt securities, or their own debt (often called "agency bonds" or "agencies"). One reason their stock was attractive to many investors is the fact that, as "government-sponsored enterprises," they could borrow at lower rates than other private corporations in order to buy mortgages for their own portfolio or to sell to other investors. They used this ability to borrow cheap in order to leverage themselves above 30 to 1 (some analysis suggests as high as 60 to 1).
With all that leverage, they built huge portfolios for themselves: $727 billion for Fannie and $712 billion for Freddie as of 2008 (see this excellent opinion piece from economist Larry Kudlow published yesterday). These portfolios have been extremely lucrative for their employees and their shareholders. Although any private company or individual who leverages himself to such an extent in order to try to make money risks bankruptcy if the investments go awry, Fannie and Freddie have always operated with an "implicit" understanding that the government would stand behind them in a crisis, which is exactly what happened on Sunday afternoon when Treasury Secretary Paulson made that backing explicit.
While we might wisely choose not to invest in entities with so many red flags, as U.S. taxpayers it turns out that we don't have a choice. Thus, as portfolio managers, we must also be concerned about the impact these entities can have on the entire financial system and the economy.
All taxpayers are liable for sharing the losses of Fannie and Freddie, even if they didn't have the opportunity to share in their gains. This is what is called "privatizing the gains and socializing the losses," and it is a situation that the opinion staff of the Wall Street Journal has been vociferously warning against since 2002, in a series of articles available from this Journal page (wittiest title: "Speaking Truth to Fannie" from March 12, 2003).
To the extent that the Fed holds off on raising interest rates in order to ease pressure on these two troubled behemoths, the damage to the purchasing power of everyone's dollar due to inflation hits everyone. The giant capital infusions to Fannie and Freddie offered in Sunday's Treasury announcement would also have an inflationary effect and further rob citizens of the purchasing power in their currency.
The situation with Fannie and Freddie shows the wages of socializing: because the government stood behind them (with your money), Fannie and Freddie took risks that they never could have taken if they had been regular private companies without the safety net of taxpayer dollars, and borrowed money at a price they never could have gotten without that same safety net.
Some defenders of this socialization of Fannie and Freddie say that it is necessary in order to help more people buy homes than would otherwise be able to do so. However, economist Wayne Passmore of the Board of Governors of the Federal Reserve argues otherwise, according to research he did of the actual numbers involved, in this report published in December of 2003. Similarly, we argued in our latest quarterly commentary that these attempts at "social engineering," such as the Community Reinvestment Act, only serve to create inefficiencies, and ultimately hurt those they were intended to help.
In the 2003 report, Dr. Passmore states: "The GSEs' implicit subsidy does not appear to have substantially increased homeownership or homebuilding because the estimated effect of the GSEs on mortgage rates is small." He goes on to say, "My calculation also suggests that roughly 42 percent to 81 percent of the GSEs' market value is due to their implicit government subsidy."
This same pattern is common whenever government interference removes penalties for irresponsible behavior: greater risks will be taken in pursuit of profits, and the intended benefits from the government intervention will turn out to be minor or nonexistent. In the end, the taxpayers will have to pay the wages of socializing, whether they saw the red flags and warning signs, or not.
For later posts on the same subject, see also:
- "The wages of socializing, revisited" 09/08/2009.
- "What Rube Goldberg could teach us about economics" 12/08/2009.
- "Bubble alert!" 06/07/2010.
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