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July 28, 2008

Bagehot's Rule and the Cost of Being "Technically Insolvent"

John P. Hussman, Ph.D.
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Just a note – Interest rate trends turned sufficiently hostile last week, and the previously oversold condition of the market was sufficiently cleared, that we lost the evidence required to continue holding our 2% exposure to index call options. While we often see large and extended rallies even during bear markets (the 2000-2002 bear contained 3 separate advances of 20%), rising interest rates have historically tended to cut such rallies short. We liquidated our call position on Wednesday's strength, placing the Strategic Growth Fund back in a fully-hedged position. I have no particular views regarding short-term market direction, except that there is a small and growing “tail risk” to the downside. We'll certainly see short-term selloffs being cleared by short-term bounces, but investors should weigh that non-zero crash risk seriously against any inclination to “buy the dips,” at least until interest rate pressures become more constructive.

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Congress passed an emergency housing bill over the weekend, raising the government debt ceiling by $800 billion to $10.6 trillion. The FHA was authorized to refinance up to $300 billion in mortgages. In order to qualify for the FHA loans, lenders would take a write-down on the existing mortgages, and homeowners would have to share future home price increases with the government. Generally speaking, my impression is these FHA refinancing provisions of the bill are reasonable. Unfortunate, but reasonable.

One shortfall of the bill is that it doesn't appear to impose sufficient costs on Fannie Mae and Freddie Mac, given that those institutions bought so many bad loans originated by careless lenders. Over the past decade, Fannie and Freddie have dramatically increased the size of their “retained mortgage portfolios” in an attempt to boost earnings. In dollar terms, the increase has been more than 10-fold. As a percentage of total home mortgages, the portion held directly by Freddie and Fannie for their own portfolios has grown from about 5% of total mortgages in 1990 to more than 20% today. This was not required to enhance housing affordability or availability. It was pure profit-seeking, with the risk borne by U.S. taxpayers.

With the fresh prospect of major debt issuance, further weakness in the U.S. dollar is virtually inevitable. Expanding on an already strained fiscal deficit (see last week's comment), the U.S. is again being forced to issue a mountain of government liabilities, which will be absorbed primarily by foreigners. This will force a fresh deterioration in the trade balance, depriving the U.S. economy of the natural tendency of its trade balance to improve during periods of economic weakness.

Stanford economist Ronald McKinnon has long argued that public policy obligating taxpayers to act as the “lender of the last resort” should be constructed in accordance with “Bagehot's Rule.” British economist Walter Bagehot's early and influential work on the management of financial crisis has a particularly important prescription as it applies to mounting credit failures in the U.S. financial system: “very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.”

Bagehot's name has surfaced in a few editorials in recent weeks, but they have invariably focused on the "lend freely" portion of his advice, while overlooking Bagehot's admonition to impose costs, capital requirements, and other safeguards where public funds are concerned. In short, liquidity should be available to Fannie Mae and Freddie Mac, but the interest rates charged should be very high. This would create natural disincentive against further bad lending practices. Though it is too late to save the current housing bill, subsequent legislation should explicitly include provisions to charge high interest rates on the government-provided liquidity. It is in the public interest for Fannie and Freddie to continue to operate, but they shouldn't stand to earn a private profit at taxpayer expense. High interest rates on government provided liquidity would also encourage these institutions to rely on private capital rather than taxpayer support wherever possible.

One might argue that the public has an interest in bolstering the profitability of Fannie Mae and Freddie Mac in order to rebuild capital. No it doesn't. The public has an interest in the solvency and continued operation of those institutions, but as soon as market conditions normalize enough that these institutions can shift their capital needs from taxpayers to lower-cost private financing in the pursuit of profit, they should have an incentive do so. High interest rates on freely available government capital would satisfy these objectives. In contrast, the easy availability of low interest capital, aided by the policies of the Federal Reserve in recent years, spawned the bad lending and the soaring defaults that we currently observe.

The cost of being “technically insolvent”

The larger problem with the bill is that Fannie Mae and Freddie Mac were given open-ended government guarantees through January 2009. This open-endedness is a big mistake, because the potential costs are being as vastly understated as the pre-war estimates of the Iraq invasion. The Congressional Budget Office and Treasury Secretary Paulson suggested that probably only $25 billion in emergency funding will be required. They estimated that chances are even that none of the funds will be required, with less than a 5% chance that the companies would need $100 billion. These estimates threw the needle of our BS meter so violently into the red zone that we're still trying to pry it loose.

William Poole, the former head of the St. Louis Fed, calls the $25 billion figure a “place holder.” I couldn't agree more. Already, Fannie Mae is currently most likely operating on infinite leverage, because all of its shareholder equity has probably been wiped out. I expect that we will hear more about this within the next few weeks.

Back in 2003 when all of these problems were quietly hatching, I noted in Freight Trains and Steep Curves that accounting rules allow Fannie Mae to keep balance sheet losses out of earnings. If you miss that, it will send your entire analysis of Fannie's difficulties out of whack.

See, in the first quarter of this year, Fannie Mae reported a $2.2 billion earnings loss. While that was a large figure, it doesn't seem like the kind of loss that would panic Wall Street (and in fact, the stock jumped 5% the day the loss was reported). Moreover, Fannie's reported book value (shareholder equity) was still around $39 billion, little changed from prior quarters. The problem comes when you dig deeper into Fannie Mae's 10-Q (specifically, Table 32), which indicates that the estimated fair value of Fannie Mae's net assets (shareholder equity) plunged from $35.8 billion at the end of 2007, to just $12.2 billion as of March 31, 2008. It is the likely deterioration since then that has led various observers to call Fannie Mae “technically insolvent.”

What's fascinating about the recent panic about Fannie's solvency is that none of this should have been a surprise to Wall Street. Investors were actually informed of this problem in May, when Fannie Mae delivered its earnings call and the stock was still trading in the 30's. That call included this bit from Steve Swad, Fannie Mae's Chief Financial Officer:

“The fair value of our net assets was $12.2 billion at the close of Q1. That represents a $23.6 billion decline from Q4. There are two key items to consider here. The first one is, the severe widening of the mortgage to debt spreads led to an $8.4 billion Q1 decline in the fair value of our portfolio. The second item is, an increase in the fair value of our guaranty obligation, what we call our “GO,” contributed approximately $16 billion to the decline. The increase in GO was driven by two factors. First we saw an increase in the underlying risk of the credit guaranty book to business as delinquencies increased and declining home prices caused mark-to-market values to worsen. This accounted for approximately 40% of the increase in our guaranty obligation. Second, the risk premium that is considered in the fair value of the GO also went up. The best evidence of this is what we are seeing around pricing. We and the rest of the market are pricing up for the risk we see. This causes the GO to go up. So the higher prices we charge on a guaranty business in March, had the effect of increasing the value of GO on the historical book.”

Put simply, the fair value of Fannie Mae's shareholder equity (the difference between assets and liabilities) plunged by two-thirds during the first quarter alone. Fannie's obligations most likely now exceed the fair value of its assets.

Looking ahead, the most likely source of oncoming losses will most likely be that “guaranty obligation” – what Fannie will have to pay out to cover losses on the $2.4 trillion book of mortgages that it is obligated to guarantee, apart from an additional trillion in mortgages that Fannie holds for its own account. That “guaranty book” exists because Fannie and Freddie buy mortgages from other mortgage lenders, “enhance” them with credit guarantees, and then sell the guaranteed securities into the open market. As Ben Bernanke noted earlier this year, “Today, the two companies have $5.2 trillion of debt and MBS obligations outstanding, exceeding the $4.9 trillion of publicly held debt of the U.S. government.”

Only a few percent of that total is likely to go into foreclosure, and even then, a good portion of the face value of these mortgages will be recovered through the foreclosure process. But do the math - the $25 billion cost estimate being tossed around amounts to just one-half of one percent of the outstanding obligations of these institutions.

Contrast that with the facts. As of June, 2.5% of U.S. mortgages were in foreclosure, and 6.4% of mortgages were delinquent, according to the Mortgage Bankers Association. Given still high rates of default for sub-prime and Alt-A (low-document) loans, it is reasonable to expect that at least 4% of the mortgages held or guaranteed by Fannie Mae and Freddie Mac will ultimately fail by 2009 (when the open-ended commitment of the government sunsets). Assuming a 50% recovery rate, which is about what banks are running on foreclosure recoveries lately, the losses on the retained mortgages and the guaranty books of Fannie and Freddie would already exceed $100 billion. That, not the unrealistic $25 billion figure, is a plausible and possibly conservative lower-bound of what the government's open-ended commitment to these institutions will cost.

Market Climate

As of last week, the Market Climate for stocks was characterized by unfavorable valuations and unfavorable market action. The deterioration of interest rate conditions, as well as interest-sensitive stocks such as utilities, was sufficient to remove the evidence for holding 2% of our assets in index call options. Accordingly, the Strategic Growth Fund closed those call option positions on Wednesday's strength. The Fund is presently fully hedged. Though we can't rule out further recovery in stock prices, we lack evidence from valuations, market action, interest rate pressures and other factors to accept an exposure to market risk. This is true from the perspective of both speculative and investment merit.

It is one thing to speculate / soften our hedges in response to evidence that has historically been associated with strong recoveries even during bear markets. That's what drove our 2% exposure to index calls in recent weeks. But it is another thing to speculate on a further market recovery when there is no evidence aside from a feeling that maybe stocks have had enough, and investment advisors are kind of bearish, and maybe things will get better. For us, the potential for a recovery isn't enough. We require market conditions across a variety of domains (valuation, market action, etc) which have historically been associated with adequate returns per unit of risk, on average. What that is not true, we simply hedge the risk. In other words, we aren't fully hedged here because I have a strong expectation that stock prices will decline in this specific instance. We always have to allow for the possibility of movements in both directions. Rather, we're fully hedged here because of how stocks have historically behaved on average in similar conditions.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and unfavorable yield pressures. Given the developing weakness in the U.S. economy, widening credit spreads (that typically reduce monetary velocity by encouraging demand for cash and Treasury securities as a safe-haven), and the growing evidence of economic weakness in other countries, my impression is that we will observe a substantial easing of inflation and commodity price pressures as the year continues. That said, we are also facing a substantial expansion in Treasury issuance as a result of the government backstop to the mortgage market. Presently, that factor is driving interest rates somewhat higher.

There are two ways to force government liabilities into the hands of foreigners (which we will have to do since our domestic savings are insufficient to fund another large expansion in the federal debt). One way is to discount the government liabilities through lower bond prices and higher interest rates. The other is through Dornbusch-type “exchange rate overshooting.” In this event, the value of the U.S. dollar would effectively plunge, setting up expectations for a subsequent appreciation sufficient to encourage demand for U.S. Treasury debt and to absorb the new issuance.

Ultimately, we can expect either further bond market weakness, or alternatively, a dollar crisis. Our investment position leans toward the prospect of a dollar crisis, but not aggressively. Accordingly, the Strategic Total Return Fund continues to carry a relatively modest 2.5 year duration, primarily in U.S. Treasury securities, with just over 15% of assets in foreign currencies.

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