It has been a longstanding
policy of the federal government to support the housing and mortgage markets in
a variety of ways. Americans are given tax incentives such as the mortgage
interest deduction and a limited exclusion of gain on the sale of a personal
residence. During the last decade, the Federal Reserve has often set the fed
funds target rate below the inflation rate, which has predictably encouraged
borrowing and discouraged savings. Another major means of support, although it
is less obvious, has been the federal government’s sponsorship of three
enterprises, Fannie Mae (FNM), Freddie Mac (FRE), and the Federal Home Loan
Banks (FHLB).
FNM was created in 1938 as a
federal agency and converted into a private corporation with a federal charter
in 1968. FRE was created as a private corporation in 1970 with a similar
federal charter. The US Government sponsored both enterprises, without
providing any explicit guarantee of their obligations, in order to facilitate
the purchase of mortgages in the secondary market. Banks and other mortgage
lenders could sell the mortgages that they originate to FNM or FRE and use the
proceeds to make more loans. Loan originators were now incentivized to make
larger loans but not necessarily to collect them since the loans had been sold
to another party who was responsible for collection. Furthermore, while the
government-sponsored enterprises provide credit like banks, they do not raise
funds from demand and time deposits. Thus, the inflationary impact (directed at
real estate) of their rapid growth is not captured by the money supply
definitions.
Martin Hutchison, a
financial writer, argues that guarantees by FNM and FRE on many American
mortgages enabled the standardization of mortgages because investors relied upon
the FNM or FRE guarantees and no longer attempted to analyze the credit risk of
individual mortgages. Contrary to the purpose of FNM and FRE, however,
securitization of mortgages appears to have increased the cost of financing a
home since more parties became involved. During the last 30 years, the average
spread between interest rates on 30-year mortgages and U.S. Treasury bonds has
increased by about 50 basis points.
As of 9/30/07, FNM reported
$39.9 billion of stockholders’ equity to support a total book of business
(mortgages owned + MBSs guaranteed and sold to others) of 2,762.4 billion. The
ratio of stockholders’ equity to total book of business was 1.4%.
As of 12/31/07, FRE reported
$26.7 billion of shareholders’ equity to support a total book of business of
$2,102.7 billion. The ratio of stockholders’ equity to total book of business
was 1.3%.
Although FNM and FRE are
highly leveraged, both have AAA credit ratings on their senior debt. They lack
an explicit guarantee by the US Government, but they are considered too big and
too important to fail. Their credit ratings are based largely upon their status
as government sponsored enterprises, in spite of the fact that top US government
officials occasionally deny the existence of any government guarantee.
The three government
sponsored enterprises now account for 90% of new mortgage financing. According
to the Financial Times, at the end of 2007, FNM and FRE accounted for a record
75% of new mortgage financing, twice the share they had at the end of 2006. The
FHLB system accounted for an additional 15% of new mortgage financing by making
advances to member banks against mortgage collateral.
On March 31, 2008, Fannie
Mae introduced a minimum credit score for purchased mortgages, although it said
that it may still acquire loans with lower credit scores in certain
circumstances. Prior to the change, there were no credit score requirements.
The maximum loan to value on mortgages purchased under standard eligibility
criteria for purchase money mortgages on 1 or 2 unit principal residences
remained at 95%. In a separate announcement during the same week, FNM told loan
servicers that they can increase their forbearance period on delinquent
borrowers to as much as six months to allow more time to seek alternatives to
foreclosure.
In spite of all the mortgage
paper that could be sold to FNM and FRE, there are some mortgages that do not
meet their purchase criteria. Subprime and Alt-A mortgages were nevertheless
pooled and sold to investors as mortgage backed securities (MBSs) in different
tranches, with the highest priority tranches often receiving AAA credit
ratings. Unfortunately for the investors that bought these MBSs, the credit
rating agencies underestimated the default rates and the probability that real
estate prices would decline in the future. Many of the MBSs could not find
bidders at a price anywhere near par value. Consequently, the Federal Reserve
initiated the Term Auction Facility to help banks and other financial
institutions. By temporarily swapping up to $400 billion of US Treasuries for
MBSs held by major banks and broker/dealers, the Fed broke the financial logjam
and helped financial institutions avoid huge writedowns. The “temporary” swaps
are expected by some to remain in effect until Congress establishes a RTC-type
agency to buy the MBSs from the financial institutions, helping preserve capital
at financial institutions by having taxpayers buy the MBSs at prices that
private investors are unwilling to pay.
James Grant, editor of
Grant’s Interest Rate Observer, was interviewed by Pimm Fox of Bloomberg on
3/25/06. He had a negative assessment of the Federal Reserve’s recent attempts
to support the mortgage market by accepting MBSs as collateral. He believes that
the federal apparatus (Fannie, Freddie, FHLB) is attempting to releverage the
financial system to counter the credit contraction that is occurring in the
private sector.
The Fed is the issuer of a paper currency now
backed increasingly by, I would suspect, a highly dubious type of collateral.
This is a very, very big problem for all of us, and especially for the humble
souls who save money rather than speculate with it. What the Fed is doing….is a
corruption of central banking and a corruption of the currency….It’s a desperate
gamble to rescue from the precipice our mortgage market. And again, let us
pause for a moment and reflect that this is happening not in a depression. We
have brought this upon ourselves, collectively, through unexampled
incompetence…..This is the greatest failure of ratings and risk management
ever. It is a scandal.
Grant’s assessment of Fed
policy leads him to be more concerned about inflation, although others argue
that “credit crisis is about the destruction of credit,” which would normally be
accompanied by deflation:
So extreme and violent is this intervention by
the Fed and so risk-fraught, it’s taking aboard of these mortgage obligations as
collateral, that the chances of a .... worldwide loss of confidence in this
piece of paper of no intrinsic value have gone up….The chances of calamity are
never great but the chances of a dollar-based calamity, I think, are much more
significant now than they were. Tail-risk has moved now rather toward the
middle of the conversation. I think the risk over the medium-term horizon - 1,
3, 5 years - is a very severe inflation.
George Soros, a prominent
hedge fund manager, believes that the current financial crisis is different from
others that we have experienced and represents a tipping point for the financial
markets:
The current financial crisis was
precipitated by a bubble in the US housing market. In some ways it resembles
other crises that have occurred since the end of the second world war at
intervals ranging from four to 10 years. However, there is a profound
difference: the current crisis marks the end of an era of credit expansion based
on the dollar as the international reserve currency. The periodic crises were
part of a larger boom-bust process. The current crisis is the culmination of a
super-boom that has lasted for more than 60 years.
Additions
Huaneng Power
International, Inc. (HNP) and its subsidiaries develop and operate power
generation plants in China. HNP currently owns 17 operating power plants, and
has controlling interests in 13 operating power companies and minority interests
in 5 operating power companies. The company plans to invest $8.9 billion by the
end of 2010 to reach a capacity goal of 60,000 megawatts. HNP currently sells
for 13.5X estimated earnings for 2008 and has an expected dividend yield of
5.2%.
Ashford Hospitality Trust,
Inc. (AHT) is a real estate investment trust that invests in the hospitality
industry at all levels of the capital structure, including direct hotel
investments, first mortgages, mezzanine loans, and sale-leaseback transactions.
AHT currently owns 114 hotels with 26,295 rooms. Brand names include Marriott,
Hilton, Hyatt, and Starwood. The current dividend yield is 14.0%.
Arc Energy Trust (pink
sheet: AETUF or Toronto: AET-UN) is one of Canada’s largest conventional oil and
gas royalty trusts, with a proved and probable reserve life index of 12.5
years. About 43% of reserves consist of natural gas. The trust has a current
dividend yield of 9.5%. Dividends received by U.S. unit holders should be
classified as qualified dividends that are taxed at lower rates.
SK Telecom (SKM) was
repurchased after being sold last August. SKM is South Korea’s leading mobile
communications service operator. In the fourth quarter of 2007, SKM bought
Hanaro Telecom, which is South Korea’s 2nd largest fixed line
operator with 25% of the market share for broadband services. SKM is a 6.6%
shareholder of China Unicom and has a joint venture in Vietnam. SKM currently
sells for 10X estimated earnings for 2008.
TeliaSonera AB (pink sheet:
TLSNF, Stockholm: TLSN) provides telecommunication services in the Nordic and
Baltic countries, Spain, and the emerging markets of Eurasia, including Russia
and Turkey. Its majority-owned companies have 35.2 million subscribers, and its
minority-owned companies have an additional 78.8 million subscribers. The
company believes in returning excess capital to shareholders and paid a dividend
in April of 4.0 Swedish krona (1.8 ordinary + 2.2 extraordinary), which
represents a dividend yield of 8.9%. TLSNF currently sells for 10X estimated
earnings.
IShares Silver Trust (SLV)
was purchased recently. SLV is an exchange-traded fund that invests in physical
silver. Each share represents approximately 9.9 ounces of silver. Although the
price of both gold and silver declined sharply in late March, many major silver
dealers (U.S. Mint, Kitco, Monex, Amark, Perth Mint, CNI Numismatics, and Ampex)
were reported to be sold out of silver and unable to fill new orders. Given the
Federal Reserve’s apparent intention to debase the US currency, SLV is a good
currency alternative.
The Investment Grade
Municipal Income Fund (PPM) was purchased at a discount to net asset value of
approximately 14%. The tax-exempt closed-end fund has an average credit rating
of AA, utilizes leverage equal to 41% of total assets, and has a tax-exempt
dividend yield of 5.2%.
Deletions
Both Nuveen Select
Maturities Municipal Fund (NIM) and Nuveen Select Tax Free Income Portfolio 2 (NXQ)
were sold as the discount to net asset value for both closed-end funds declined
to 2%.
Positions in Methanex (MEOH)
were reduced to a normal portfolio weighting. While industry inventory levels
remain below average, product prices of methanol have declined from historically
high levels. There is a possibility that product prices will decline further
due to an economic recession and additional industry supply.
Chunghwa Telecom (CHT) was
sold at a profit after the company disclosed a 10-year foreign currency
derivative contract that requires payment if the Taiwan dollar appreciates
relative to the US dollar. For the month of February, a charge for unrealized
valuation loss on the contract reduced earnings by 44.5%.
Updates
The price of Trina Solar
Limited (TSL) stock rose recently after the company announced a polysilicon
supply contract with a subsidiary of GCL Silicon Technology Holdings. GCL will
supply TSL with virgin polysilicon sufficient to produce 2,600 MW of solar
modules over 8 years. Delivery of polysilicon, which is currently in short
supply, will begin in April 2008 at predetermined prices. TSL has now secured
95% of its estimated polysilicon feedstock requirements for 2008.
If you have any questions
regarding your accounts, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.