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To: orkrious who wrote (194203)	9/28/2002 2:07:38 PM
From: orkrious	Read Replies (1) \| Respond to of 436258

good letter to Richard Russell posted on his web site today Hey, R-Man: It's been a while, but at long last there seems to be a topic in your daily commentary maybe I can help with. The topic is FNMA. You mentioned in your commentary today that FNMA stock has been tanking. True. You posited that the reason behind the decline might be that the housing market is rolling over. Perhaps also true, but I beg to differ. So far unspoken of are the potential effects of the massive declines in U.S. Treasury interest rates on financial institutions. The general reckoning is that falling interest rates tend to be helpful to the bottom lines of these entities, and typically this line of reasoning has been on target. The problem currently is that we have entered into a "brave new world" of interest rate levels. Yields have fallen to levels never experienced by a single professional populating the brain trusts of all of these entities. The way in which portfolios have been constructed has been contextualized, understandably, by the career experiences of these individuals. But presently these experiences have been rendered irrelevant. Which takes us to FNMA today. This is an entity which borrows huge amounts of money which is deployed in turn into huge amounts of mortgage-backed securities at a hoped for higher yield to create an earnings spread and a bottom line profit. This enterprise is aided and abetted by government cooperation, because FNMA is able to borrow at highly attractive rates based upon their linkage to an assumed government bailout, should the need ever arise. Over the past twenty years, FNMA has grown profits steadily and managed their risk admirably. But now we have entered into the "brave new world". Their management systems, and the professionals that created them and utilize them, never contemplated the "out of sample" reality that is now being experienced. The lowest-ever in interest rate levels now in place have led to the highest-ever refinancing reality in the world of mortgages, a reality not contemplated by either the models or the professionals. As a consequence, the payback on the mortgage assets invested in by FNMA is likely to occur at a level not even considered by the models or the professionals, which has led to a very large mismatch between the life on these assets and the much more stable life on the liabilities funding them. Result: the portfolio of mortgages runs off very quickly, while the high cost liabilities remain. This is a recipe for low, and in the extreme case, even negative earnings. That, I think, is why the FNMA stock price is down. And it is not an isolated incident; financial companies of all ilk are exposed. Falling rates have turned into the enemy, not the friend, of this sector. Last point: how enthusiastic will the government be regarding a FNMA bailout if it is perceived to be yet another example of management incompetence, however unfair that assessment might be? Or is it unfair, or just, another manifestation, quite unexpected, of The Bear?