QUEER EYE FOR THE BOND GUY:
Fanny Mae as the Bond Canary
Jim Willie CB January 12, 2005
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Fanny Mae deservedly receives a tremendous amount of criticism. It has become the mortgage industry poster boy for uncontrolled inflation, accounting fraud, executive pilfering, and collectivism for home ownership. More could be said about probably the largest wellspring of funneled theft in the history of the United States, as much as $3400 billion from 1988 to 2000, but that is another story, and besides, I value my health, freedom, and well-being too much to document such claims. What massive cash flows, fraudulent siphons divert money.
In all likelihood Fanny Mae is downright insolvent and bankrupt. The Dept of Treasury has taken over their hedge book in the past summer months. The financial press failed to properly report what happened. How about a column title "Fanny Mae Bankruptcy" ??? No no no, that would make for a negative story on a wonderful device to enable home ownership to over 65% of our public. The Dept of Treasury punted to the Security & Exchange Commission, which will merely force accounting restatements, and probably punt back to Trez. A ping pong game will ensue. It cannot be permitted to stop, since publicity of the formal announcement of bankruptcy would again make for bad press. The centrifuge must continue. The game must perpetuate without end, so as to avoid that day of reckoning. In movement comes no final determination.
In effect, the USA is in the process of repeating the error committed by Japan late in the 1980 decade. The USA is gearing its entire mortgage finance structure to over-priced housing property, inflated by perhaps 40% to 50% in value. Whereas Japan suffered bank damage from underwater mortgages, scattered in its bank under-writing across the terrain of the Land of the Rising Sun, inside the USA suffered damage will occur in a localized manner with Fanny Mae and the other Govt Sponsored Enterprises (i.e. Freddy Mac, Federal Home Loan Association). To be sure, the debris of potential under-water mortgages is scattered across countless Savings & Loans and mortgage banks inside the US Economy. Talk about a weapon of mass destruction! And Asian central banks hold the button for detonation. We no longer have control, either with the internal accounting or foreign influence.
This essay is not an attempt to fully analyze the paper pyramid known as Fanny Mae, nor to fully document its fraudulent game, nor to fully articulate its risk. My purpose is to propose the Fanny Mae stock (FNM) share price as a leading indicator of the upcoming bond bubble breakdown, and a leading indicator of bond derivative events. FNM will herald the future bond bear market. We have already experienced our first derivative event with Fanny restatement from hedge book corrosion. However, it has so far been contained, much like a nuclear power station enclosed by a 10-foot (3-meter) cement containment module. Our federal banking officials are venting radioactive gas every single day, every single week from the receivership containment module. Such is the nature of monetized Fanny debt.
First, some background so readers can benefit from some measure of information on its controls, auditing, accounting, risk management, and foreign credit reliance.
INADEQUATE CONTROLS
To be sure, Fanny Mae and Freddy Mac stand as the centerpiece to a grand mortgage finance centrifuge system which dispenses mortgage funds to agencies and banks in a monstrous recycle. New mortgages are approved and funded by agencies of all kind, only to sell portfolios to Fanny Mae, to receive the funds right back, and to repeat the grant of new mortgages. Firms which manage new loan creations earn nice origination fees (points). The risk management and accounting problems cited for this spewing machine are many. Banking authorities such as the Federal Reserve cannot seem to contain or control the growth of money from this system. Perhaps 25% of new money supply growth in 2003 and 2004 was traceable to Fanny Mae and the other federal pools of mortgage supply.
INADEQUATE QUALITY AUDITS
Audit controls are a ridiculously funny joke with Fanny. Agency held mortgage portfolios can legally be audited only in the aggregate, so bad loans are easily buried and hidden. That is the law, designed as a large wide patio sliding door for fraud. A rash of patterned under-capitalized loans cannot be identified. A scad of grossly over-valued properties cannot be identified. A raft of loans with kickbacks cannot be identified. Worse, a funnel of systematic (see the HBO Sopranos) criminal fraud loans from shell corporations cannot be identified either. In fact, Fanny itself manages a recycle game which is possibly complicit to the scam with "Reperforming" loan portfolios, and sells bonds to back them up. They label certain loans as defective, recycle the faulty parts into another aggregate package, and sell the defective product to the public at a discount. Their quality is uncertain, but certainly sub-par. Would you purchase 100 televisions if you knew 10% were defective? How about at a discount?
INADEQUATE REQUIREMENTS
Agency held mortgages entail minimal requirements for qualification. Applications are routinely accepted with 5% down payment, closing cost rebates under the table, and worse. Appraisals are widely regarded to be a joke. If an appraisal professional offers reasonable and lower estimated values for properties under application, he or she will quickly be excluded from the grand game. The inspection process has been undermined, since the centrifuge will spin out funds even for properties with problems. Remember the "Reperforming" products? Inspectors are subject to similar pressure to comply and play the game. Mortgage insurance, no problem.
INADEQUATE ACCOUNTING
The recent SEC decision to require restatement of $9 billion in Fanny Mae losses highlights the exposure of the fraudulent nature of this massive shell game of a centrifuge, with attached funnels. They have systematically put aside hedge book disasters into the nether regions of amortized losses, or else to hidden them into accounts to be reckoned with at later dates. Games have been played to delay loss reporting so that executive stock options were redeemed with profit, fully reported last May by Barrons. This is where public scrutiny and outcry will possibly result not only in criminal trial, but also in cancellation of millionaire pensions for the perpetrators. Be assured that somebody in Fanny's executive ranks will be prosecuted and will sport an orange prison jump suit, probably not well connected politically, possibly a past whistle blower, perhaps even an official who wears the wrong colored political party coat.
DANGEROUS RISK MANAGEMENT
Fanny Mae has the unenvied task of managing a gigantic mountain of bonds, with different interest rates, different lengths of maturity, different loan size, different regional markets, and different income levels of borrowers. Their business plan might not be possible to execute successfully without a deity in charge of risk management. If mortgage rates fall, the "refinance" movement wreaks havoc with their accounting, as pre-paid bonds plummet in value. Refinanced funded proceeds usually are devoted to Treasury bond recycle, which used to push rates even lower from sheer magnitude. Proper hedging is a careful craft, not easily achieved, and Fanny might have fallen way short in its success. While falling rates render portfolios of bonds as rising in value, the lost income from cash flow in refinances could render operations totally drained in liquidity. In other words, the business would run out of money to maintain operations. If mortgage rates rise, then bond portfolios could quickly crater, especially with leverage. Worse, they might be forced to sell into their bond futures portfolio to raise required cash, which accelerates rising long-term interest rates. This is called "mortgage convexity." Derivatives are at work to contain the Ponzi Paper Mountain with US Treasury Bonds (i.e. bond futures contracts). There is more, as Real Estate Mortgage Investment Conduits (REMIC) are employed to contain the mountain attached to the centrifuge with Mortgage Backed Securities (MBS). These are leveraged contracts on mortgage bonds. A mistake in a declining rate environment, and they are dead. A mistake in a rising rate environment, and they are dead. There are many more devices employed, such as interest rate swap options (called swaptions). There are strips which remove payment to principal. There are floaters, which balance against international prevailing rates. Enough, getting a headache here. Oy oy oy.
FOREIGN CREDIT RELIANCE
It is estimated that 25% of all official Agency bonded debt is purchased and held by foreigners, such as Asian central banks. Not only are foreigners the major credit suppliers to keep the USGovt funded on deficits (45% share), but they are also major credit suppliers to mortgage funding. Of course, they gobble up corporate debt, like 25% of it. What better way to keep US homeowners able to borrow endlessly against their increased home equity, for the typical consumer purchases, room additions, and maintained lifestyle. Does that mean Asian bankers will eventually own a large swath of American property titles? Hmmm.
WEAKEST LINK IN THE BOND STRUCTURE
The financial markets constantly seek out simple indexes, worthy indicators, and other measures to aid in reading complex markets. Given the overwhelming characteristics of financial weakness, which any rational thinking person cannot deny, the Fanny Mae stock can be placed in the fish bowl for view as the best indicator of approaching disaster. Stock prices typically forewarn of fundamental distress and trouble over the horizon in 3 to 9 months time. If mortgage bonds are to suffer a horrible fate in future months, the FNM stock price will surely take a nosedive. Or at least, imminent "recognized" insolvency might be tipped off by a bearish chart pattern. To date, no such warning can be put up for view. My analysis has long accepted FNM as the crack in the housing foundation from a financial perspective. In my view, the cracks are widening, the cracks are growing in length, water is leaking, and new cracks appear periodically. My conclusion is that the future will bring the bond bubble bust, the great anticipated bond bear market, the crash to do unspeakable damage to the US Economy, AND FANNY MAE STOCK PRICE WILL PROVIDE THE BEST AND MOST RELIABLE WARNING.
Some might disagree and look for siren signals from mortgage agencies, from title trusts, from home builders. These public companies are often shielded by Fanny Mae itself, since they offload risk to Fanny themselves. These firms are not part and parcel to foreign central bank portfolios. No, the real bond decline will come when foreigners shed their US bond holdings. Their mortgage agency debt securities are the most likely initial dumping ground. If trade war erupts, the first Asian salvo will surely be mortgage bonds. They contain much more risk, and are more insecure than Treasury securities.
Let's examine the above FNM chart. The mortgage congame stock price seems safely bound between 65 and 75 per share. There is no rounded top pattern, which might alert investors of imminent decline. The roof to the Fanny chart house seems tilted downward, but hardly any severe listing to prevent the liquidity to drain inside to sleeping or living quarters. Some measure of confidence might even be garnered from the upward tilting lower support in the current trading range. Together with a tilted rooftop, the building base indicates a time of resolution in the coming months, or else just a more dangerously narrow range. As the range tightens, the tolerance for swings is removed, adding to the risk of breakdown.
Four events can be identified in the FNM chart. Some correlation can be seen with the TNX chart, which corresponds to the 10-yr Treasury Note yield. They do not perfectly coincide though, since Fanny contains much more risk on its own demerit. Event A marks a quick swoon in FNM over 20% in value, from 78 to 60 during the late summer of 2002. At that time, the US Economy was showing early signs of recovery (whether real or not), bonds were rotating into stocks, and the first of several bond revolts occurred. Event B marks from January to March 2003 the misfortune which befell Fanny, as the stock from 70 to 60, almost a 15% decline. St Louis Fed Governor Poole provided impetus for the climax selloff. He had warned that the mortgage finance giant was grossly under-capitalized, its derivative book had insufficient core funds, its accounting was suspect, and its failure could cause a meltdown to the US Economy as a systemic risk. Well put, Poole! It is a wonder he was not fired from federal service like former Treasury Secretary O'Neill.
Event C marks in midsummer 2003 some more fibrillations (heart attack) from yet another bond revolt. Its stock fell from 75 to 61, almost a 20% decline again. At this time, much publicity had circulated that Fanny and its mortgagor sisters had lost control, and had run amok beyond what reins the Federal Reserve could pull. Reports cited over 25% of all new money in the banking system had been generated from mortgages. The usual suspects of Treasury bonds, corporate bonds, commercial loans, credit card extension, and financial sector carry trades now had a new member in the Grand Inflation Financial Engineering Club. Much talk swirled around stories of Fanny insolvency and critically wounded hedge books.
Event D coincided with reports that Fanny Mae was exposed and cited for financial accounting fraud, executive option fraud, and likely earnings restatements of the severe downward variety. The reports soft-pedaled the story of bankruptcy and entry into receivership to the Dept of Treasury. Can't have that! The stock fell as precipitously as it did in the summer 2002, as shares fell in value from 78 to 67, hardly a crash.
Rumor is rampant that Fanny Mae stock and its gargantuan pile of fatty debt is the beneficiary of an historically unprecedented massive remedial rescue LIPOSUCTION project. The Federal Reserve, administered by the Dept of Treasury, is printing money (monetization) and purchasing Fanny paper in order to prevent its collapse. If Fanny were subjected to free market forces, it would quickly enter bankruptcy court, see FNM go to 35 cents per share, and cause a tsunami wave with other private agency bankruptcies. Even if somewhat contained, such a development would surely cause the long-awaited decline with awesome momentum in the US housing sector.
To date, FNM shows no signs of a bond breakdown, a bond bear market, or liquidation of the bankrupt Fanny Mae corporation. Is it a corporation, or a federal agency, or just a financial engineering madcap apparatus whom nobody will lay claim to ownership down the road? It is clearly on life support, with large intravenous infusions being administered on a daily basis. The accounting probably can be found offshore. Fanny's inevitable fate might be a formal socialist basket case like Social Security Trust, which also was stolen dry, but in full view.
FANNY MAE STOCK (FNM) SERVES AS THE CANARY IN THE BOND COAL MINE. WHEN IT GOES INTO DECLINE, BE PREPARED FOR A BOND BEAR MARKET. GOLD REQUIRES SUCH A BOND BEAR TO TEAR DEEP WOUNDS IN FALSE MONEY. WE ARE NOT THERE YET, BUT A NARROWING RANGE MAKES FOR A CHALLENGE
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Jim Willie CB is a statistical analyst in marketing research and retail forecasting. He holds a PhD in Statistics. His career has stretched over 23 years. He aspires to thrive in the financial editor world, unencumbered by the limitations of economic credentials. Visit his free website to find articles from topflight authors at www.GoldenJackass.com.
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