FNM, the Carry Trade, & other thoughts
beacon1.rjf.com
We were reminded of this verbal exchange between the aforementioned characters from the hit series M*A*S*H while talking to our friends at theStreet.com last week when they asked us, “What is the most important thing confronting Wall Street currently?” While most pundits will offer up consensus concerns, we suggested that the key concern is can the “carry trade” be unwound in an orderly fashion or not? Recall that the “carry trade” consists of borrowing money at say 1%, leveraging that money at 10:1 (or more), and investing that leveraged money in a vehicle with a greater return than 1%, in many cases via the derivative
markets. While “conservative” types might buy the 3-year T’Note, which when levered 10:1 produces double-digit returns provided the yield curve doesn’t dramatically change, more aggressive types tend to buy junk bonds given their 9%+ yield. Even more emboldened players lever into anything with a derivative contract that is going “up” in price; be it stocks, bonds, gold, copper, etc. With more than 7,500 hedge funds out there, the carry-trade has become ubiquitous. Indeed, the notional value of monies “wound up” in the carry-trade is north of $150 trillion! Obviously, with that kind of money involved more than just the hedge fund community is playing the carry-trade game. And, one need look no farther than the balance sheets of most of the big banks, brokerage firms, and yes Virginia . . . corporate America, who are employing the carry-trade for their own proprietary accounts. In past
missives we have mentioned numerous marquee companies that are generating the lion’s share of their earnings from this technique. However, the poster child of the carry-trade seems to be Federal National Mortgage (FNM/$69.90/Market Perform) . . . aka Fannie Mae. Amazingly, Fannie Mae appears to support nearly $1 trillion in debt, as well as $1 trillion of derivative risk, on a mere $22 billion worth of equity. Consequently, we were stunned recently by a story that appeared in the Wall Street Journal. The headline read, “Fannie Withholds Balance Sheet, Post 2.1% Drop in Net Income.” Before we read the article questions ran through our mind. Do they not know what the values should be on the balance sheet, or is there something on the balance sheet they don’t want people to know? Assuming it is the former, how can they know what they earned if they don’t know what they own and owe? What does it mean for a financial institution that has assets to equity in excess of fifty times, and total assets exceeding that of the Federal Reserve Bank, to not have all their debits and credits in good order?
Reading the article did not answer these questions, but did raise others. A Fannie Mae spokeswoman revealed that the information would be released later in the quarter and added that the company wanted to do “as much fact checking as possible” of the data. Taken at face value, this statement suggests that management has some reason to question their internal controls. We cannot fault them for being careful on this count given the penalties for corporate executives in Sarbanes-Oxley.
The article goes on to quote a source suggesting the delay is a result of ongoing negotiations with the Office
of Federal Housing Enterprise Oversight. This source is quoted as saying, “That which you do not state you
do not have to restate.” We are certain the good people at Fannie Mae feel the pressure of current regulators, and the heat of congressional hearings regarding potential additional regulation, the same way an ant feels when a young boy discovers a magnifying glass. A “bear” on the stock is interviewed and suggests they are hiding something, most likely a drop in stockholder’s equity. An analyst with an outperform rating defends the company with, “It’s disappointing not to have the information in the release but their explanation for the delay seems reasonable.” We ignored both these comments, as we know that bulls and bears tend to talk their own book.
The article concludes by allowing that Fannie Mae had first quarter losses of $959 million on its derivatives
portfolio. The company is reported as arguing that those mark-to-market losses are a misleading picture of
its overall portfolio. Tell that to your margin clerk next time you get a margin call. Fannie urges investors to
focus on “core business earnings,” which strip out fluctuations in the value of derivatives. To which we ask, if “core earnings” are such a better measure of profits why not just get out of the derivatives business? As Warren Buffet stated in the 2002 Berkshire Hathaway (BRK.A/$93,300) shareholder letter, the derivatives business is a lot like hell, “easy to enter and almost impossible to exit.” Directly or indirectly, most of corporate America is involved with derivatives. It is difficult to find an annual report that does not have a footnote on FASB 133, the accounting standard that controls reporting of derivative transactions. Fitch Rating Service recently reported that the notional amount of over-the-counter derivatives was nearly $170 trillion with over 90% of the largest corporations worldwide using derivatives to manage or hedge their risk. Clearly, derivatives are pervasive.
Alan Greenspan thinks well of derivatives and claims they have done a good job of risk distribution. Warren Buffet, and his partner Charlie Munger, call derivatives “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” The anecdotal evidence supporting the “Maestro” is the fact that during the recent recession, which saw the largest corporate bankruptcies in history [Enron (ENRNQ/$0.04) and WorldCom (MCIAV/$17.55)], no major bank experienced distress. The anecdotal
evidence supporting the Oracle of Omaha are the portfolio insurance impact on the crash in 1987, Orange County and other debacles in 1994, and the near meltdown of the financial markets in 1998 due to the derivative deviates at Long Term Capital Management. Clearly, derivatives are controversial.
Our concern is that derivatives in general, and interest rate swaps and total return swaps in particular, have
helped make the economy and financial markets hypersensitive to short-term interest rates, much less the
insanity of valuing long-term assets based on over-night interest rates. Nevertheless, the markets of late are
reacting dramatically to the mere discussion of when a quarter-point increase in rates might occur. Liquidity
and short-term rates have always been a factor in markets; however, the old rule of thumb was it took three increases by the Federal Reserve before markets took a hit. We believe that multiple factors have made the markets hypersensitive to short-term rates. The above mentioned derivatives, the emergence of the financed-based economy, the pervasiveness of the carry-trade, the leverage in hedge funds and margin accounts, and last but not least the debt-to-GDP of the U.S. economy. Even if we accept the low reported rates of inflation (which we question), real rates of interest are currently negative. A return to a more normal relationship between inflation and interest rates is too painful to contemplate. The resolve to face such pain will not return until inflation again becomes much bigger
problem. Recently, we got an inkling of what can happen when just a small portion of carry-trades are unwound as
stronger economic numbers were reported with a concurrent swoon in the interest rate complex (read: higher rates). While we understand the “hit” to the bond and stock markets, the inflationary bias numbers should have been a plus for precious metals and the attendant “stuff stocks” . . . aka tangible assets. Regrettably that just wasn’t the case as gold, copper, et. al. had a substantial downside dump. Manifestly, we attribute this to the money levered into these investment vehicles via the carry-trade. Also compounding the situation was the renewed strength of the dollar, which as often mentioned is the “measuring stick” U.S.-based participants use to value said assets. Clearly, we have been worried all year about such events, which is why we hedged most of our “stuff stock” positions using covered call option writing techniques at the end of
last year. Yet, believers in our secular bull market in “stuff” theme (energy, timber, agriculture, base metals,
precious metals, etc.) should take heart since we think the dollar rally is close to being over. Further, we can
make a pretty cogent argument that the economic strength is waning as well. Consider this. Last year’s tax rebate checks are over and the tax cuts are already “baked” into the system. Moreover, the upcoming tax breaks should have little benefit for the general public. Additionally, the recent “backup” in interest rates should actually mute economic activity going forward . . . alas the problem with
prosperity. Consequently, we can make a case that economic activity will fade from here and with it all the
talk of higher interest rates. While this could allow the carry-trade to continue, our sense is that a flattening
of the yield curve will also “cap” the proliferation of said trade. Unfortunately this continues to leave us with a
trading scenario for the equity and bond markets, especially given the fact that “cash earnings” (read: not
financially engineered earnings) are merely back to where they were in 1997. If this view is correct, the major indexes should remain range bound and the secular bull market in “stuff” should continue, which is why we have been recommending buying back our covered call writing hedges when individual securities positions pull back to support levels. We also continue to think that a number of
individual special situations remain interesting in the mid-cap universe of stocks. Further, we can still find a
number of international markets that look “cheap,” as often reprised in these missives. We continue to invest accordingly.
The call for this week: Evidently Fed Governor Ben Bernanke is as concerned about the carry-trade as we are given his comments last Friday. To wit – rapid interest rate changes may impair the GSEs (governmentsponsored entities like Fannie Mae) to hedge effectively. And, maybe that’s why Fannie Mae broke below its 200-day moving average last week, causing one old Wall Street wag to lament, “When the lead dog of a finance-based economy breaks down that is not particularly a good sign!” Still, our sense is that stocks will try to stay “up” into the upcoming May 4th FOMC meeting where the bias statement will mean everything.
Between now and then . . . “carry on!”
M |
