Fannie and Freddie Distort the Market
The Fed Hits the Brakes
Contradictions: The Fed vs. the Bond Market
Where's the Market Discipline?
Even More Contradictions
By John Mauldin
October 17, 2003
Two weeks ago we examined the changes in our lives. Last week we looked at
imbalances in the economy. This week the theme that I see in my daily
reading is the large number of major contradictions apparent in the
markets. There are so many contradictions we will not get to them all, but
let's start, as it will make for some interesting and controversial
analysis.
Fannie and Freddie Distort the Market
The main contradiction we will deal with starts with a lunch conversation I
had with bond market analysts and guru Jim Bianco two weeks ago in Chicago.
Jim is one of the smartest analysts I know and is a fascinating font of
information.
We were talking hedge and macro funds, and he asked me what I thought was
the best "trade" I saw. I answered that for aggressive traders, I liked
the Eurodollar options. I will explain them in more detail below, but they
are pricing in a Fed interest rate rise of over 1.75% by December 2004,
which is just 14 months from now. I opined as how I did not think there is
a significant chance of such a magnitude of a raise actually happening, and
that I could not understand how the bond market could actually believe the
Fed would raise rates that fast.
Jim replied, "They don't. The Eurodollar futures mis-pricing is a result of
Fannie Mae and Freddie Mac distorting the market." As he explained his
reasoning, and as I have thought about it since then, I think he may have
an answer for part of the puzzling contradiction between what the Fed is
saying and what the market is pricing.
First, the Fed cannot be any clearer about their intention to keep short
term rates low. A "considerable" period is how they term it. One Fed
governor told us a few weeks ago that a considerable period is 18 months.
That is past the end of 2004.
Typical is what influential San Francisco Fed President Robert Parry, the
second longest serving Fed policymaker, had to say:
"The rise in long-term interest rates since summer has already taken the
wind out of the refinancing boom, which put so much money in people's
pockets. Core inflation, which is already under 1.5%, may slip even lower.
The recent period of weak investment demand has not only led to a fall in
inflation, but it has also depressed economic activity.
"Thus, there is less concern about surprises that could push the inflation
rate up, and more concern about surprises that could push the inflation
rate lower, possibly even leading to deflation."
For now, let's simply take the Fed at its word that rate increases are not
in the near term future. Except that the bond market seemingly does not
take the Fed at its word, nor do the futures market imply anything close to
trust or belief. My "favorite" trade I mentioned to Jim got crushed this
week. There are two ways to bet on or hedge interest rate risk and
direction. You can invest in Fed fund futures or Eurodollar futures. (Fed
fund futures are typically used for shorter term moves and Eurodollar
futures are used for longer term hedging. That is because after a duration
of about one year, the Fed funds futures markets are not very liquid or
sizeable, and the Eurodollar markets are where the huge action is, as we
will see.)
The September '04 Eurodollar contract implies that the Fed will raise rates
by 1.25 % over the next 11 months. If you go to December '04, rates are
expected to rise by 1.71% and if you go to December 2006, the market
apparently thinks short term Fed fund rates will be 4.96%, almost a full 4%
rise. Can you say 9.5-10% mortgage rates, boys and girls? That also implies
that inflation plus growth will be well north of 6-7%.
But wait, there is an odd fact within the very markets. If you go to the
Fed funds rate for August of '04, there you find that rates are expected to
rise only 0.75%. The market is saying that just one month later rates will
rise by a full half percent.
The market is saying that Alan Greenspan is going to raise rates by 0.5%
just 45 days in advance of what will be a very close presidential election
(on top of the 0.75% they think he will have raised by August). Further,
the market is implying that the economy, or inflation, or both will be so
strong that Greenspan will have no choice but to do so.
I am not going to dispute that the economy is not growing strongly. It
clearly is. It could grow at an above trend pace for well into next year.
That makes me happy. But I think there is some inherent weakness in this
recovery that makes it more suspect than others recoveries we have
experienced since the end of WW2. As we will see, I find it hard to believe
that there is something in the economic water that could cause Greenspan to
raise rates 45 days in front of an election.
Let's go to my favorite macro analyst, Greg Weldon, and look at some of the
data he slices and dices in his latest Money Monitor, arguing that there
are no rate increases in our future. (www.macro-strategies.com)
"Bottom Line: over the last FOUR months, the annualized rate of decline in
US Average Weekly Earnings is (-) 1%. Without income reflation [growth in
personal income], there is virtually NO ladder for inflation to climb,
ESPECIALLY under the auspices of CONTRACTING money supply." (quote with
edits) Think about that. No growth in income in the strongest quarter in
many a year.
"... without income gains, wealth reflation will be the SOLE support going
into an election year." By wealth reflation, Weldon means stock market and
housing price gains. Yet that might be in jeopardy as the Fed actually
appears to be tapping on the brakes by tightening the money supply.
The Fed Hits the Brakes
He documents at length the significant recent slow down of growth of M-2
and M-3. He asks: "CAN wealth reflation in the US withstand the TIGHTEST
monetary conditions since the last great stock-market wealth DEFLATION ???
....with the tightest monetary stance via long-term-of-short-term M3, since
1997."
Then he offers this very interesting data from the Philadelphia Fed Survey:
"While ALL the focus was on the admittedly robust OUTPUT data, we note the
less-focused-upon "Special Question" segment of the survey, which asked:
* If you experienced a decline in Production during the 2001 Recession
(72.5% of all, did), has Production returned to pre-2001 levels? 85.7%
replied NO.
* Then, If not (85.7% of the 72.5%), WHEN do you expect Production to
return to pre-2001 levels? 53.1% said between 2Q-4Q 2004 ... BUT the rest,
over 43%, said "Not in the Foreseeable Future".
"Indeed, nearly a THIRD of ALL firms stated that Production is NOT likely
to regain pre-2001 levels. YET, money supply [growth] is trending well
BELOW the degree of stimulus that was on the offer, since pre-2001.
"FAR WORSE, in the macro-secular sense, is this final tidbit from the
'Special Question' segment of the Philly Fed:
"23.4% of the 85.7% of ALL firms that originally stated that Production had
not reached back to pre-recession levels, said they did NOT expect
Production to reach back to pre-2001 levels ...BECASUSE of ... "Long-term
Decline in the Industry."
"Indeed, note the Fed's own text ... 'Moreover, a large percentage of firms
(44 percent) do not expect production to return to those pre-recession
levels in the foreseeable future, for reasons involving competitiveness or
longterm declines in their industries.'"
"YEAH, [he writes sarcastically] lets TRIPLE the Fed Funds rate!!!"
The headlines you read talk about how jobs are getting better. If you look
at initial claims, you might get that idea. They are below the
psychologically important 400,000 and are dropping ever so slowly.
Comparing the real numbers with last year, there is a slight improvement,
which is good.
But Continuing Claims are rising, and back to levels seen earlier this
year. Taken together, this means that fewer people are losing their jobs,
but fewer are also finding jobs.
Let's reflect upon that for a moment. We are told the economy grew by
something like 6% in the third quarter. That means with inflation we are
talking a nominal rate of over 7% and maybe 8%. That is as powerful as it
has been for a long time.
And yet, no jobs. No income growth. As Weldon notes elsewhere, only 2% of
those firms surveyed said they were paying lower prices, with 25% paying
higher prices, yet 72% say they have no pricing power and are unable to
raise prices.
Let's look at where the out-sized growth came from last quarter. Stephen
Roach tells us 2% of real GDP growth came from automobile sales in the last
two quarters. Consumers, supplied with a tax cut and massive home equity
financing from the second quarter as rates briefly dropped to historical
lows, took the heavy incentive deals they were offered on cars which were
also priced lower than this time last year.
"Surging expenditures on consumer durables [mostly automobiles] accounted
for about 2.0 percentage points of annualized real GDP growth, alone, over
the past two quarters. To the extent that such an impetus did not reflect
the fundamentals of pent-up demand, a payback of like magnitude would not
be surprising. Historical experience does, in fact, tell us that's the norm
after any spike in durables spending -- let alone the excessive one of the
past two quarters. Since 1960, there have been 16 instances of excessive
growth in durable goods consumption (defined as an annualized growth
contribution exceeding 1.5 percentage points of real GDP) that contributed,
on average, 2.2 percentage points of annualized real GDP growth; in the two
quarters that followed, the growth contribution slowed dramatically, on
average, to just 0.1 percentage point. To the extent such a payback is
likely after the current spending burst, it could act as a sharp depressant
on overall demand growth in subsequent quarters. That development, in the
context of a lingering jobless recovery, could raise serious questions
about the staying power of America's current cyclical resurgence." (Stephen
Roach of Morgan Stanley)
Could auto sales maintain this level for one more quarter? Perhaps, as
small business people all over America come to the end of the year and
realize that under the current tax code, if they buy an SUV which weighs
over 6,000 pounds (Lincoln Navigator, Cadillac Escalade, Lexus, Chevrolet,
Ford, etc,) they may be able to deduct the entire cost from their 2003
taxes. In essence, the government just made these monsters more affordable
than smaller cars at two-thirds the price.
(Yes, to my shocked readers in Europe, a 1986 tax rule provides that small
businesses can deduct the cost of commercial vehicles, which are defined as
small trucks which weigh over 6,000 pounds, which in the US includes large
SUVs. The Bush tax stimulus package allows small businesses to deduct up to
$100,000 of capital business expenditures immediately per year, up from
$25,000 if I remember right. The idea was to get businesses to buy more
computers and equipment and furniture, etc. Under the current rules, SUVs
also fit into this category. Only in America.)
The good news is that the US economy apparently grew 6% in the third
quarter of this year, and should do well this quarter and into the New
Year. But this is a stimulus led recovery, and where will the next shove
come from? The Bush administration has to hope that oil will drop to around
$20, or that rates will somehow come back down.
Roach says, and I agree, "Eager to jump-start the US economy prior to the
upcoming presidential election, the Bush Administration focused on front-
loaded tax cuts that were designed to have maximum impact in 2004. "Spring-
loaded" was the term used by Treasury Secretary John Snow to describe the
growth potential of these measures. Well, the White House may have gotten
more than it bargained for. The risk, in my view, is that the policy
induced stimulus occurred sooner than expected in 2003 -- leaving the US
economy having to face the "air-pocket" of a payback in early 2004.
Needless to say, that would come during a period of maximum vulnerability
insofar as the election cycle is concerned."
Let's be very clear. There are some very positive signs in the economy.
Revenue growth seems to be picking up. There are some anecdotal signs that
employment might be starting to rise, although it has not shown up as yet
in the data. Housing is still relatively strong, and consumer spending is
growing.
Further, I am not complaining about the stimulus driven recovery. Recovery
is a good thing. If any of the Democratic presidential hopefuls were
currently president and actually pursued the policies they espouse, we
really would be experiencing the worst economy since the Hoover
administration. Without the combined and powerful stimulus of the Bush tax
cuts, federal deficits and Fed engineered lower rates, it is difficult to
imagine anything but a severe post bubble and post 9/11 recession.
(The best thing the Republicans have going for them is Howard Dean, who
increasingly reminds me of Michael Dukakis, another very liberal
Northeastern state governor who came from nowhere to win the Democratic
nomination only to go down in flames in the general election. This country
might be ready by election time for another centrist Democrat like
Lieberman, but a far left Democrat, which Dean clearly is, is not in the
cards.)
The point that I am trying to make with the litany of data I provided is
that this economy cannot withstand higher interest rates. Do you think home
sales, mortgage refinancing and consumer spending, not to mention auto
financing and other debt-driven consumption, is ready for higher rates?
This economy is vulnerable in a way that no 6% growth economy in my memory
has ever been. If the Fed actually raised interest rates by 1.75% within
the next 14 months, pushing mortgages close to 8%, increasing financing
costs, impacting home sales and home values, how long would it be before we
were staring at a recession and another serious stock market correction?
Further, interest rate increases are dis-inflationary at best, and in this
environment, could actually foster deflation. Go back to Parry's statement
above, and compare it with scores of other recent Fed speeches and
releases. They are worried about the "surprise" of deflation. They see the
softness and vulnerability. This is not a Fed that will raise rates until
reflation in incomes, pricing power and business investment has
demonstrated an ability to sustain themselves in spite of rate increases.
Contradictions: The Fed vs. the Bond Market
Yet, the bond market is pricing in such rates. What are these guys reading
(or smoking)? Are you and I, dear reader, the only ones who can understand
the clear language of the Fed? Or are we gullible little fish who cannot
see through the lies?
And now we come to Bianco's insight. He points to Fannie Mae and Freddie
Mac as the culprits for the contradiction between Fed talk and market
rates.
Ginnie Mae (the Government National Mortgage Association) is totally owned
by the US government and run by the Department of Housing and Urban
Development (HUD). Its debt is truly government guaranteed.
Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal
Home Loan Mortgage Association) are private companies. Their debt is not
explicitly guaranteed by the government. They do have a $2 billion line of
credit with the Treasury which they could use in a liquidity crisis.
But the market treats their debt as if it is guaranteed by the US
government. That means Fannie and Freddie can borrow money at much lower
rates than can, say, J.P. Morgan or Citibank. I suppose you can argue that
is a benefit to consumers, as it does mean that home mortgage rates can be
lower as well.
But what Fannie and Freddie have become are Government Sponsored Hedge
Funds. Management has taken advantage of their "special" relationship and
uses it to increase private profits for shareholders and large salaries,
options and bonuses for management.
Essentially, they lend long and borrow short. Since short term rates are
lower than long term rates, they pocket the difference. They increase their
profits by the use of very large amounts of leverage.
This is known as a "carry trade," and is a regular practice of hedge funds
and other investment companies. There is nothing wrong with this. Some of
my favorite funds practice this type of investing. Properly practiced, it
can produce some steady, if not spectacular, profits.
What Fannie and Freddie do is what good hedge funds should do. They go into
the futures market to hedge their interest rate directional risk. You see,
if short term rates were to rise above the average rates they have lent to
their long term mortgage buyers, they could find themselves in the position
of losing money. Lots of money. So they hedge.
They do this in the Eurodollar futures markets. They use swaps or options
on swaps called swaptions. (Swaptions are options contracts which, in
return for a one-off premium payment, give you the right to enter into a
swap agreement at the option expiration.) Again, nothing wrong with this.
Bianco notes the problem lies in that they need over a Trillion Dollars
(that's with a "T") of these derivatives. In order to get a trillion
dollars to line up on the other side of the trade (to take the risk from
Fannie and Freddie), they have to pay a premium. Apparently it may be a big
premium.
Bianco argued at lunch, in the shadow of the Chicago futures markets, that
it is not the expectations of bond traders for actual rate increases, but
the massive need for Fannie and Freddie to hedge its portfolio that drives
the Eurodollar rates.
Why do Fannie and Freddie need such high-powered hedge exposure? Because if
they acted like Ginnie Mae, their profits would be much less, stock price
growth would be lower and management would not get the fancy pay packages
and option incentives.
Do I think Fannie and Freddie are at risk today because of this? No, I am
not saying that, and neither is Bianco. But there is a limit.
Frank Raines wants to grow his firm (Fannie) 15-20% a year. Where are they
going to find more credit worthy risk takers/speculators on the other side
of the swaps trade?
Let's be very clear. They could not do this if the market did not price
their debt as if it were backed by the US government. The "spread" would
not be there. Otherwise, Citigroup and Morgan and other investment banks
would be significant competitors.
As long as the market sees that level of risk, the game can continue. But
what if they simply try to get too big? How long can you grow a finite
market 20% compound a year? What if there is a hiccup? How quickly would
the risk premium for the Eurodollar rise? Not very long. The technical term
is a "jiffy," which is the name of an actual unit of time which is 1/100 of
a second. (The things you learn as you read. Thanks, Art.)
First, if there were a problem, the US Treasury would step in within the
next jiffy to provide whatever cash was needed. No administration, Democrat
or Republican, will let the US mortgage market and home values crash due to
a "liquidity event" at Fannie or Freddie. Think the Savings and Loan crisis
was big? It would be a picnic compared to a major problem with Fannie and
Freddie. The implicit guarantee the markets perceive is actually quite
real. These firms are too big and too important to fail. The ultimate
insurance tab, however, is picked up by the US taxpayer.
For every $100 billion their "hedge book" increases, the costs for
acquiring the hedge is evidently rising. What is the point when we get to
"too much?" I don't know, and neither does anyone else. We may be a long
way from there, or maybe not.
The point is that a private company seeking private gains should not be
putting the entire US mortgage market and the US taxpayer at risk, even if
they think the risk is small.
The management of these firms is comprised of very smart men and women, and
I am sure they employ some of the smartest PhDs anywhere to run their hedge
book. But so did Long Term Capital Management.
Where's the Market Discipline?
The problem with Long Term Capital Management (LTCM) was that there were no
market restraints or market discipline on the firm. Greed drove all those
investment banks to lend LTCM money in the lust for commissions, and LTCM
refused to show any of the firms their "hedge book." You can bet if the
investment banks had seen their total exposure, they would have reined the
Nobel Prize management team in, in very short order.
But who is looking over Fannie's shoulder? "Don't micro-manage us," say
Raines. Translation: don't mess up our gravy train.
Everyone seems to acknowledge that federal oversight is weak. There is now
a bill in Congress to move the oversight to the Treasury Department, but
Fannie and Freddie lobbyists have so watered down the bill that it is worse
than the current situation. If oversight goes to the Treasury under the
current guidelines, that increases the implicit government guarantee and US
taxpayer exposure. But if creates no real controls.
If Fannie and Freddie want the advantage of an all but explicit government
guarantee, they should open their hedge book to complete scrutiny and be
subject to leverage curbs. At a minimum, they should be made to shorten
their duration risk exposure (another risk which I will not take the space
to go into, but which is real enough).
Yes, under such a situation they will not make as much profit as they do
today. But so what? Why should a small group place the rest of us with a
large risk, even if it is thought to be remote?
We would scream if a Morgan or a Citigroup or some other private firm would
be allowed to put US taxpayers at risk for private gain. What is the
difference with Fannie or Freddie?
Alan Greenspan argues, and I think rightly, that the Fed should manage not
for the more likely of problems, but for the possible problems which would
cause the most harm. It is better to tolerate some problems than to
experience a problem which could lead to disaster.
The mortgage debt market is now larger than the government debt market. One
can make an argument it is the most significant piece of the US economy.
Why take any risk at all?
Yet, if Bianco is right, the bond market sees more than a little risk, and
that is why interest rate futures are priced so high in the face of the Fed
telling us rates are going nowhere. If there were no risk to this trade,
there would not be such high risk premiums.
Congress needs to shorten the leash on Fannie and Freddie. Public or
private. In or out. But not both. Perhaps Fannie and Freddie are right.
Maybe the risk is low. But so was the risk to Long Term Capital. It is a
risk that US tax-payers should not take, are not paid to take, yet Congress
has let the lobbyists convince them otherwise.
More Contradictions.
How can we once again be in Bubble valuations? Amazon at a P/E 0f 151,
Priceline at 220 and the list goes on and on. Caroline Baum points out the
China has lost 10,000,000 manufacturing jobs in the last few years due to
productivity increases. Who do the Chinese politicians blame? Who is their
currency scapegoat? Our politicians on both sides of the aisle pander to
our nationalistic tendencies, as do politicians world-wide. Do we really
want China to risk major turmoil and a reactionary return to a
nationalistic world. Think Germany in 1932.
What of the clear contradiction between the argument for free trade and the
seeming arrival of protectionist sentiment upon every shore throughout the
world?
Enough. There are just too many, and it is time to go home.
Let me suggest that the hedge funds and major traders who read me might go
to Greg Weldon's web site mentioned above and contact him directly. He has
a rather pricey (several thousand a year) service in addition to his less
expensive retail letters. I am sure he will send you a few weeks' samples.
They are worth every penny if you are "working the markets."
If you would like to meet in New Orleans October 29-31, please let my
office know. If you have already written about getting together, you
should have been contacted by now. Have yourself a great week.
Your almost ready to finish his book analyst,
John Mauldin
John@FrontLineThoughts.com
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