Fannie and Freddie: Burnt Offerings

February 28, 2008

There is creativity and then there is desperation. The real question these days is finding that fine line and recognizing the difference.

The FED and the financial powers has thus far been classified as creative in their “handling” of the credit crisis. Yesterday, during a very exciting (?) testimony from Fed Chief Bernanke, a news item flashed across the wire that Fannie Mae (FNM) and Freddie Mac (FRE) will reduce the spread caps, thus allowing for additional capital and credit to flow into the economy.

The timing of the OFHEO announcement is at best suspicious and very worrisome. It came too close to the discussion by the FED about their understanding that there is a significant housing problem and there are more problems projected. There is clearly a need for additional capital directed towards consumers who are in a credit stranglehold. Yet, this seems to be more of a desperate move and a gamble on the future security of the credit markets. Remember, the reason why there were caps in the first place:

From the OFHEO: Since agreements reached in early 2004, OFHEO has had an ongoing requirement on each Enterprise to maintain a capital level at least 30 percent above the statutory minimum capital requirement because of the financial and operational uncertainties associated with their past problems. In retrospect, this OFHEO-directed capital requirement, coupled with their large preferred stock offerings means that they are in a much better capital position to deal with today’s difficult and volatile market conditions and their significant losses.

Excuse me, but a release of the cap will help to keep their problems in check? Surely there are different problems now and the 30% cushion helps to keep the stability of the quasi-agency companies during times when write-offs and write-downs are growing. The cushion is analogous to the loan-to-value that homeowners are required to have as they buy their homes.

One of the problems that helped to enhance the mess that we find ourselves in was the lack of a belief that old-fashioned loan and risk management procedures were of no consequence. Bad assumptions were/are standard operating procedure (SOP) and we now know that it was not the best way to operate.

— Andrew’s Book – The Disciplined Investor is available at Amazon and other fine retailers —

So, when markets are elated with the news that the CAP cushions are going to be lifted with FNM and FRE, don’t be upset when you see a continuation of massive losses. Rest assured they will continue to flow like a raging river for some time to come.

Why? Here are some of the headlines into this brilliant plan:
– Freddie Mac Posts Wider Loss of $2.5B in 4th-Qtr As Loan Defaults Mounted
– Big loss for Freddie Mac
– Fannie Mae posts nearly $3.6B loss in 4Q
– Moody’s Warns ‘Sizable’ Losses May Be Ahead for Fannie Mae
– Moody’s puts Fannie Mae rating on review
– Freddie Mac posts wider loss of $2.5B in 4th-qtr as loan defaults

The fact that Moody’s is looking into downgrading these names is one of the few murmurs of sanity that can be separated from much of the rhetoric that is being bantered about. It is clear that the companies that are in dire need of credit expansion (builders, retailers) may be acting on a last-ditch-effort approach that will have them spin positive on any plan, no matter how detrimental it will be to our financial health. noted on FRE: The company’s estimated regulatory core capital was $37.9 billion at the end of 2007, $3.5 billion in excess of the 30% mandatory target capital surplus directed by OFHEO.

The core capital may seem like a substantial number at first glance but put that into perspective against the backdrop of an estimated mortgage portfolio of $1.8 trillion. In addition, the losses that have been reported for 2007 are more than they have experienced in the last 7 years. FRE is also reporting that the average current adjusted loan-to-value ratio for their single-family home portfolio has been increasing steadily over the past few years. It now is 60%, up from a low of 56% in 2005.

Even so, they have 16% of subprime ARM loans that are 90-days or more delinquent or now in foreclosure. This is far greater than any time over the past 10-years. ARMs are considered Hybrid Mortgages and as this category currently makes up 17% of their portfolio, there is reason to be cautious.

FRE Delinquencies

As housing prices continue to decline, loan-to-value ratios will continue to suffer. This is just one more part of the larger concern that investors will have to ingest as they are asked to commit more funds in the form of debt and preferred stock offerings. In the face of a credit rating panic, it will be interesting to see how they adjust their portfolio strategy to ensure that investors see the highest rating available in order to efficiently peddle their debt at the lowest cost.

Either way, FRE and FNM will surely have a higher cost of operations as they move forward. Everything points to lower net earnings and higher investor anxiety.

FRE Housing Prices

Chronic borrowers will be excited as there will, in theory, be more of the credit-drug available to help get them deeper into a their debt-hole. But do not make the mistake as an investor that it may be time to jump in. This move will have a negative effect and eventually weakening FNM and FRE. Simply using debt-to-equity ratios as a proxy for loan-to-value will show that this is more of a creative mechanism for credit to flow that will have the near-term effect of throwing these two companies under the bus.

We have no change to our outlook for these companies (see Mortgage Mayhem 11/21/07) and continue to warn investors that this type of gamble may lead to further solvency issues rather than balance sheet stability. Any downgrade (hard to fathom?) will also create a greater problem as the cost for asset-backed credit will eventually be need to be paid by….you and me! These will take the form of a tax burden that will be left to be cleaned up by the “winners” of the upcoming election.

The bottom line: FRE and FNM are being thrown under the bus in order to help the housing markets and in an effort to protect the credit markets. The removal of the mandatory CAP is a dangerous gamble by regulators. There is not much to say from a technical standpoint either. In the end, there needs to be a sacrifice to save the rest of us. FRE and FNM may well be the burnt-offerings to appease the credit gods.

FNM 1-Year Chart

FNM Chart
FRE 1-Year Chart
FRE Chart

Disclosure: Horowitz & Company Clients do not hold positions in any securities mentioned as of the date of publication

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Special Report: Investing During an Economic Downturn

February 27, 2008

By popular demand….

Looking for the latest report : Investing During an Economic Downturn !

The latest from “The Shield of Yield” – 18 Stocks

401k Problems

February 26, 2008

If an impending recession, credit crisis and housing meltdown wasn’t enough, there has been a ruling that will now allow for workers to sue their employers if they have losses in their 401k plan. That’s right!

Now, employees may be able to have a defensible position that actually allows for recovery if they lose on investments of their choosing.

This is ridiculous! Of course it is important to ensure an employees rights, yet there is some point that people are responsible to themselves.

In a time that will surely have employers scrambling to find ways to cut back on overhead, this adds a new wrinkle and the potential for liability on the pension plan that was supposed to give employees the ability to have control over their retirement destiny. Bad idea!

The Wall Street Journal reported:

The U.S. Supreme Court unanimously upheld the right of workers to sue over losses in their 401(k) retirement-savings accounts in some circumstances, but pension-law experts said a minority opinion in the case could also bolster some defenses used by employers.

The ruling yesterday could affect dozens of retirement-plan lawsuits brought by workers against their employers. Retiree advocates praised the decision. “We’re excited about it,” says Rebecca Davis, a staff attorney with the Pension Rights Center, a retiree-advocacy group in Washington.

But employers may find solace in a minority opinion by Chief Justice John Roberts, which, while concurring with the majority, appeared to offer companies a roadmap for combating similar cases in the future.

Employers — or whoever they appoint in their stead — have an established obligation to run retirement plans as “prudent experts” on behalf of participants. Failure to do so can invite litigation, says Gregory Ash, an Overland Park, Kan., pension attorney. Recent cases have included allegations that employers offered participants unwise investment choices, or allowed investment managers to charge participants unreasonably high fees.

At issue in the case before the Supreme Court was whether federal pension law, which allows lawsuits on behalf of a group of employees, also allows an individual to sue over losses in his own account in a 401(k) or similar plan.

Previous case law allowed participants to sue employers over losses on behalf of the retirement plan as a whole. But the prior ruling had arisen in traditional pension plans, in which assets are invested collectively. Employers have argued that participants couldn’t file the same kind of suit over losses in 401(k)s and other individual accounts because they didn’t represent losses to the plan itself.

Read more

TDI Episode 45: Robbin’ The Hood

February 25, 2008

WARNING AND IMPORTANT ADVICE on how to protect your portfolio and your cash. Andrew brings back essential knowledge from the Reuters Summit on Housing. In this episode we hear what is on the minds of advisors and other noted speakers of significantiTunes Subscribe influence who all had their opportunity to discuss how they believe we arrived in this dreadful position while at the same time looked for solutions. Thanks to Microsoft for inviting Andrew and providing the opportunity to attend as a guest of the MSN Money team.

Stocks mentioned: (TOL) (PPD) (BAC) (C) (MBIA) (MSFT)

** NOTE: Andrew is teaching: PORTFOLIO MASTERY on February 28 (free) Register Now. Also calls are being accepted for the upcoming advice-only episode. Leave your information and question by calling 877-623-8473. In this episode, listen for details on how to get a free audiobook. **

Audio clips are sprinkled throughout this episode from the panelists included Short Seller and Seabreeze Partners head Doug Kass, home-builder and CEO of Toll Brothers Bob Toll, Neighborhood Assistance Corp. of America CEO Bruce Marks and MSN columnist Jim Jubak.

The basic discussion surrounded the basic questions:

– Should the government bail-out home lenders and owners?
– How much further can prices fall?
– Will the consumer continue to hold up or will this trigger a recession?
– Who should take the blame?

If it was a movie, The American Dream has been renamed to: A Nightmare on Elm Street. Unfortunately, the focus of who will really to suffer has not been addressed as this quickly evolving housing situation has focused on the financial industry, lenders and Wall Street.

Andrew explores:

– Trouble for investors with certain Money Markets and other traditionally safe short term debt securities
– Credit seizure in all areas could prevent local economies/governments from running
– Pension Plan losses due to inability to price auction and asset backed investments
– State Pools (an other emergency funds) freeze if they have funds in sub-prime, junk bonds, auction-backed and asset-backed
– Student Loan market crisis looming
– Muni bonds will cost significantly more to issue as credit agencies are untrusted, driving rates down and interest payments up
– Opportunity in Rental Real Estate for investors
– Fallout for Retail and Travel/Tourism industries
– Run-on-the-bank scenario starting to build
– South Florida banks that should be on watch list
– FDIC – concern over if they handle another S&L type emergency
– South Florida auto industry implosion ( pricing, limited credit, excess inventory, poor floor-planning, tighter credit requirements)
– Mutual Fund distribution freeze for illiquid fixed income investments
– Section 8 housing flood on market as next investment opportunity as it is a possible beneficiary under one bailout idea.
– Sovereign debt drying up as a foreign countries are not only feeling their own problems, unwilling to risk in potentially illiquid positions
– Lawyers will benefit from Foreclosures, bankruptcy and liability lawsuits – Investment IDEA!

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Media and News: The Savings Game

February 21, 2008

In his recent nationally syndicated column, The Savings Game, personal finance writer Humberto Cruz interviewed me for to find out if there is: “A different way to rebalance your portfolio?” We explored a few options and he wrote: 

To be sure, this strategy — and even just rebalancing back to an original asset mix — can be counterintuitive. You have to lighten up on investments that are doing well (but have become too big a percentage of your portfolio) and buy more of the asset classes not doing as well.

“The average investor continually makes the wrong decision because they are based on emotion — fear and greed — as opposed to any long-term logical plan,” said Andrew Horowitz, a certified financial planner in Weston and author of the informative The Disciplined Investor: Essential Strategies for Success…

… They buy high or sell low, or refuse to sell for emotional rather than logical reasons.”If it’s going up they don’t want to sell because it’s going up; if it’s going down, they want to hold until it ‘comes back,'” even if the investment was a mistake, Horowitz said. Bottom line: “Investors who stick with a plan are far better off in the long term.”    

The Disciplined Investor is available at Amazon and other fine retailers. 

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