01/12/2001 The Spectacular Rise and Fall of Equity *

If nothing else, wild speculation certainly returned to the stock market this week, with The Street.com Internet index surging 24%, the NASDAQ Telecommunications index 14%, and the NASDAQ100 11%. The Morgan Stanley High Tech index, the Semiconductors and the Biotechs all jumped 9% this week. Year to date, the Semiconductors have gained 16% and the NASDAQ Telecommunications index 15%. The small cap Russell 2000 and the S&P400 Mid-Cap indices added 4% this week. It was tougher sledding for the bluechips, with the Dow declining 1% and the S&P500 adding 2%. The Transports and Morgan Stanley Cyclical index both dropped 4%. The Morgan Stanley Consumer index was unchanged, while the Utilities declined 3%. The financial stocks were mixed, with the S&P Bank index declining 1% and the AMEX Securities Broker/Dealer index gaining 2%.

It was another week of chaotic trading in the credit market, as interest rates abruptly ended their collapse and headed higher. For the week, 2-year Treasury yields jumped 32 basis points to 4.89%. Five-year yields increased 30 basis points and 10-year yields 33 basis points. The mortgage-backed market continues to be a trader’s nightmare, as yields surged 37 basis points after declining 40 basis points last week. Agency yields jumped about 30 basis points this week, after dropping 27 last week. For the week, the 10-year dollar swap spread increased 5 basis points to 89. Short rates jumped as well, with the implied rate on the June eurodollar futures contract rising 30 basis points 5.22%. It sure appears that the market is beginning to appreciate that the economy is not presently as weak as some have suggested and that inflationary pressures are greater than what has been appreciated. At least that is our view, for now. The dollar enjoyed a tepid bounce this week, gaining less than 1% against the euro.

Alan Greenspan must be darn pleased with himself. Broad money supply has surged $112 billion in three weeks ($21 billion last week), bank credit has increased $61 billion in three weeks ($32 billion last week), the junk bond market is “going nuts” (from a message that was left on my answering machine – thanks Mark!) and speculation has returned with a vengeance to the stock market. From Bloomberg, the Investment Company Institute is reporting that money market fund assets increased last week by $67.7 billion, “the largest weekly increase in three years.” And CNBC reported that Market-Trim Tabs is stating that $15 billion has flowed into equity funds since the Fed rate cut. In short, “reliquefication” is, once again, working its magic.

One comment about the stock market: Even last year, in the midst of a spectacular decline in NASDAQ, in no way was the “back broken” in what has become a hopelessly speculative marketplace. As technology stocks sank, no problem; just buy biotechs, mid-caps, utilities or financials. Apparently, even with a rout in many key technology funds, equity mutual funds as a whole never suffered even a monthly outflow (the last being August 1998!). Another year of shocking money supply expansion - $600 billion (9%) – provided a constant stream of new “liquidity” that kept the game going. So, today it should come as no surprise that truly egregious money and credit excess naturally finds its way into the marketplace, and it heads right back to the most speculative sectors. This situation is certainly one reason we repeatedly use the word “dysfunctional” in our descriptions of the U.S. financial system. The conspicuous risk of these repeated “reliquefications” is a continuation of what has over time regressed into a breakdown in the entire capital allocation process.

As mentioned last week, one of the great costs directly associated with the 1998 “reliquefication” was an historic speculative bubble and massive malinvestment in the technology/Internet/telecommunications area. And specifically because of the intense global deflationary backdrop (associated with the SE Asian and emerging market economic collapses) and vast underutilization of global manufacturing capacity, here at home there was little in the way of traditional consumer price inflation from this great credit inflation. As such, the New Economy proponents (on Wall Street and at the Fed) viewed this spectacular inflation in asset prices quite favorably (“wealth creation”). Today, the global backdrop is one of general economic strength and heightened inflationary pressures. We are left to ponder the possibility that if this “Reliquefication” continues, one of the consequences will be a surprise on the consumer price inflation front. We certainly also see huge risks in the ever expanding real estate bubble.

As we have highlighted previously, as air came out of the technology bubble last year the pumping only became more intense in the real estate sector. In many ways, the real estate bubble is of the same cloth as the NASDAQ bubble – the consequence of blatant credit inflation. And as margin debt was a critical factor in the self-feeding stock market bubble, mortgage debt feeds an historic real estate bubble. There is one major difference: margin borrowing is limited to 50% of a stock’s value. Sure, many took on additional margin debt against inflating stock prices, but the lenders had a 50% cushion to protect against losses. Thus, despite the fact that NASDAQ sank about 50% from its highs, the brokerage firms escaped suffering significant losses, although many of their customers were wiped out. Such will not be the case for the aggressive real estate lenders.

Imagine a world where “free markets rule,” and the government’s mandate that stock market margin requirements be dropped as a relic of an era of needless regulation. Security firms, anxious to reduce the “down payment” necessary to purchase equities to 30%, begin lending up to 70% against a stock’s market value. This new buying power propels the stock market higher, creating incredible profits in the margin lending (and investment banking!) business. Equity Mae (a new government-sponsored enterprise with an implied backing from the U.S. taxpayer) begins buying, packaging, and selling securities backed by margin loans, “guaranteeing the timely payment of principal and interest” on these securities.

Those behind this idea quickly see that “this could really go somewhere!” As stock prices rise and great interest develops in margin borrowing, Equity Mae sees even greater opportunities. Soon Equity Mae begins purchasing margin loans from the securities firms and “warehouses” them on its own balance sheet. Why not “play” the wide spread between the borrowing rates paid by the government-sponsored enterprise and the much higher margin rates? “It’s as close as it comes to free money! Plus, we can now issue stock and get a ‘market multiple’ on this ‘spread.’” Besides, this is “just what the doctor ordered,” as the bull market in margin lending is increasingly creating liquidity concerns for the securities firms. The securities firms, of course, throw all their considerable weight behind Equity Mae. There is, however, one sticky issue that keeps this arrangement from really reaching its true potential. Since Equity Mae is a GSE, there is this pesky “rule” that to protect the interest of the marketplace and the taxpayer, only margin loans with “equity” of at least 70% are to be purchased.

It took the ingenious securities firms no time at all to come up with a fabulous solution. Why not have these margin loans “insured” by a group of MDI (margin debt insurance) insurance companies? “Brilliant,” was the one word heard most often at the Washington headquarters of Equity Mae, “and we can just call it equity and no one will know the difference.” The securities firms are absolutely “tickled” by the prospect of unlimited liquidity for margin lending, and management at Equity Mae sees immediately how the implied backing by the U.S. taxpayer could be used to amass stunning riches from their millions of stock options. For the securities firms, they would really prefer to lend their customers up to 95% or even 100% of stock market “equity” - it’s “great business!” Not only is it good for profits it does wonders for the bull market. What a great deal! And although it wasn’t discussed much, the securities firms and their aggressive clients (who like to take big leveraged positions in MDBS - margin debt-backed securities, as well as Equity Mae IOUs), relish at the thought of always having Equity Mae around as a “partner.” Best of all, there is an unspoken promise that whenever this margin debt bubble finds itself in jeopardy, it only takes a phone call and Equity Mae will come into the marketplace as an aggressive buyer, more than happy to pay “top dollar” to support the market.

This is simply the greatest arrangement ever concocted for the stock market, with unlimited purchasing power available to investors and speculators alike. The securities firms can now dump all their margin loans to Equity Mae, trading them for “AAA” rated Equity Mae IOUs, and, better yet, providing additional purchasing power for higher yielding junk bonds, credit card and asset-backed securities. With unprecedented credit availability, the economy booms like never before. Consumers accumulate “wealth” previously unimaginable. They greatly “benefit” as rising stock prices provide huge sums of “equity” that can be easily “cashed out” through the booming market in stock market margin loans. The intoxicated consumer spends beyond his income, but “who cares” with stock market “wealth” increasing every year.

This arrangement is particularly a boon to the credit card industry, as over-indebted consumers always have stock market “equity” to fall back on. Knowing this, the credit card companies open the lending spigot to everyone. Plus, “liquidity” in credit card securities is great, with Equity Mae now buying every margin loan in sight! The securities firms make huge profits in selling credit card-backed securities, as well as all the various securities now marketed by Equity Mae. To make this all even better, the government provides tax deductibility for margin interest, so who wouldn’t benefit from taking out margin loans? Over time, Equity Mae begins to lend to inexperienced stock speculators and even those that have “blown up” their accounts in the past. But, of course, it’s in the “public interest” to provide affordable borrowings so all Americans can “invest” in the “American Dream.” And although the consumer and stock operators are basically “tapped out” of all their “equity” in the stock market – relegated to using this source as consumption levels already surpass income - that just provides more opportunities for the MDI companies to insure even larger loans. It’s good for their earnings and stock prices and certainly fine by Equity Mae as it endeavors to maintain extraordinary growth. The market doesn’t miss a beat.

During the fantastic boom, this arrangement provides absolutely stunning “wealth creation.” These new enterprises are celebrated for their financial genius, and many (especially Washington politicians) wonder why this was not done long ago. The high-profile CEO even begins to state publicly that “Equity Mae is in the risk management business.” The skeptics are dumbfounded. With all the hoopla, the stock prices of Equity Mae and the MDI companies surge on wonderful earnings growth and projections for this to continue forever. They become true Wall Street darlings. Even greater “wealth creation” is found in the credit market, where Equity Mae turns stock margin debt into “risk-free” securities – transforming billions of high-risk margin loans into wonderful “money” that even the most risk-averse could not be happier to hold. This is Wall Street Alchemy at its finest. As the stock market booms and Equity Mae’s balance sheet explodes, the few skeptics see very serious risk in this “scheme.” “What happens to the security brokers and Equity Mae if the stock market tanks?” they inquire. “No problem,” says management. “As you can see, there is rarely a loss suffered from margin lending. Sure, there were some losses years ago, but our systems are much better now. Indeed, our earnings have never been stronger and risk has never been less. Just look at our current credit losses. This proves we have mastered ‘risk management’! After all, there is tremendous equity – upwards of 40% - providing us an impenetrable cushion.” But the skeptics counter, “there have been no losses specifically because this unprecedented boom in margin lending has fueled historic stock market inflation and an unsustainable bubble. Of course, there will be few defaults and even fewer losses in an environment with sharply rising stock prices. Wait until the downturn, that’s when you will see huge losses and there is absolutely no doubt that your current allowance for losses will prove grossly inadequate.” Equity Mae, expanding its lending like never before, responds that it is protected against loss by MDI insurance, as well as other sophisticated contracts they purchase directly from insurers and the securities firms. “We use the best models.”

The skeptics, however, have a big problem with this arrangement, seeing it along the lines of a classic pyramid scheme! “Only as long as the securities firms lend aggressively, the MDI companies blindly provide the necessary insurance, Equity Mae expands credit recklessly (purchasing the loans from the securities firms), and credit market investors (at home and abroad) continue to purchase Equity Mae IOUs, will the stock market bubble remain levitated.” “It is absolutely unsustainable,” claim the skeptics, “and this reckless scheme is only providing a dangerous mechanism guaranteed to bury the unsuspecting margin borrowers in unmanageable debt as soon as this bubble bursts.”

At the very late stages of the boom, the explosion of Equity Mae holdings becomes THE KEY source of fuel for what has developed into an historic bubble economy. Importantly, Equity Mae’s massive purchases of margin loans lead to extreme distortions to both the financial system and economy. The economy overheats and stock prices diverge wildly from any semblance of reasonable valuation. Strange things start happening, from energy shortages to a sinking currency. And, while the general appearance of the boom remains the same, there are some very ominous developments just “below the surface.” For one, the hopelessly “stretched” stock market speculator aggressively “cashes out” of significant amounts of “equity” after this latest big run-up in prices. In order to fund this huge margin debt “refinancing,” the MDI (margin debt insurance) companies provide huge amounts of new insurance and Equity Mae absolutely balloons its balance sheet with “refinanced” margin loans.

The skeptics are amazed this scheme has lasted this long, but there is no doubt now that Equity Mae is “drinking the poison,” ballooning its balance sheet with loans that will soon be very suspect. As the bubble comes under intense stress, desperate moves provide one final “last hurrah” where the increasingly nervous stock speculators are allowed to fully “cash out” at “top dollar.” It does keep the game going a little longer, but the consumer, having fully spent his income, taken on huge borrowings, and “cashed out” his equity, is at the very end of his rope. Soon confidence in the entire scheme wanes and the inevitable stock market decline commences. There are huge speculator defaults on the mountains of margin loans, and the first to get “blown out” are the MDI insurance companies. After all, Equity Mae basically ensured their demise by fostering the stock market bubble and providing the means and encouragement for the speculators to “cash out” at the top of the market. Many do ponder that “it really did seem almost too good to be true at the time…” Even at only somewhat lower prices, the equity cushion is gone and defaults usher in the inevitable bear market. The thinly capitalized margin debt insurers are quickly insolvent, and all eyes quickly turn to the behemoth Equity Mae. Not long after, the world witnesses a spectacular collapse for Equity Mae, sunk by mountains of margin loans and guarantees on margin loan-backed securities, especially those created from the last of the great refinancing booms. While the devastating drop in its stock price is painful for many, the real damage is done in the collapse in the market for Equity Mae IOUs and margin-backed securities. The entire market for margin debt securities “freezes,” creating an historic systemic crisis. “But what happened to the 40% equity that you spoke of Mr. Equity Mae CEO?” asked the Congressman. “You have certainly created one hell of a mess, and we would like an explanation as to how this could have happened!”

But in truth, reality is stranger than fiction! Over the past 11 quarters (first quarter 1998 to third-quarter 2000), in what has been a key aspect of an almost continuous “reliquefication,” home mortgage lending expanded by more than $1.1 trillion, or 30%. Predictably, the results of this reckless credit expansion have been spectacular home price inflation, and resulting overspending (and massive trade deficits) by the household sector. And over this protracted boom, an amazingly aggressive superstructure of real estate finance has developed that has provided a convenient mechanism for the consumer to pile on enormous debt levels that will be very difficult to manage during the downturn. Indeed, we are today in the midst of another spectacular mortgage refinancing boom, where consumers are provided enticing rates to extract “equity,” what is really nothing more than manifestation of egregious mortgage credit inflation. Going forward, we don’t think one can overstate the importance of what is an historic and dangerous real estate bubble. It is our view that one of the costs of the current “Reliquefication” will be gross over indebtedness by the household sector and the likely insolvency of key institutions within the mortgage finance “Superstructure.” The ramifications for the U.S. financial sector and economy are momentous. The question now becomes, when does the marketplace discount this scenario, and what are the ramifications for interest rates and the dollar.

When I say that the U.S. financial sector is currently self-destructing, I say this with earnestness. This wave of mortgage refinancings, once again incited by reckless credit excess from the GSEs, is particularly dangerous. We expect huge amounts of “equity” will be extracted by an increasingly stretched household sector, and that the consequences of this final credit boom will leave the entire real estate finance superstructure holding a mountain of potential credit problems. And while it may take time for these losses to surface, the mortgage credit insurers will be at considerable risk going forward. And, we certainly do not expect this thinly capitalized industry to provide much protection to the bloated GSEs when the downturn commences in the U.S. housing market.

But, in the mean time, fourth quarter numbers are in; no surprise here. Fannie Mae increased total assets by a record $37 billion (surpassing the previous record of $30 billion during the – surprise! – fourth quarter of 1998), or 23% annualized growth rate and more than asset expansion during the entire first half. It appears this stunning growth could have even been more extreme but for the fact there was a liquidation of “investments” for year-end. For the month of December, “average investments” were almost $62 billion, while “investments” at 12/31 dropped to $55 billion. For the fourth quarter, Fannie Mae increased its mortgage portfolio at a 25% annualized rate. For the year, total assets increased $100 billion to $675 billion. Assets have now increased an astounding $271 billion, or 67%, during just the past eleven quarters (going back to the second quarter of 1998 when the U.S. financial system came under heightened stress that culminated with the LTCM debacle).

During the second half, Fannie Mae increased assets by $66 billion (22% growth rate) compared to $34 billion (12% growth rate) during the first-half. Fannie Mae’s total “book of business” – mortgage portfolio plus outstanding mortgage-back securities in which it has guaranteed “timely payment of principal and interest” - now surpasses $1.3 trillion. Meanwhile, Fannie Mae maintains “allowance for losses” of $809 million ($6 for every $1,000 of exposure!) Interestingly, while Fannie Mae’s “book of business” increased by $112 billion during 2000, its allowance for bad debts increased a whopping $5 million. Now that is some optimistic accounting!

I do ponder if management has any realization of the challenges that await. Quoting Franklin Raines, Chairman and CEO of Fannie Mae: “The year 2000 was an exceptionally successful one for Fannie Mae in a variety of critical areas. We posted our 14th consecutive year of record earnings, increased our earnings per share by over 15 percent for the second year in a row, achieved our $1 trillion affordable housing commitment ahead of schedule, and announced a set of voluntary liquidity, disclosure and capital enhancement initiatives that put us at the leading edge of financial institution practices…Fannie Mae's prospects for continued strong earnings growth are excellent. Our credit indicators are favorable, our 25 percent annualized portfolio growth last quarter gives us excellent momentum, and the current financial environment suggests that secondary market activity will remain at an elevated level well into this year.” Is Mr. Raines managing his business or the price of Fannie Mae stock?

As I see it is very interesting commentary occurring at an historic inflection point for the U.S. real estate finance industry, I will include excerpts of Fannie Mae CFO Timothy Howard’s conference call from yesterday:

“Even with the sharp declines in rates that occurred over the last couple of months, our portfolio’s duration gap was only at negative three months at the end of last year. That’s well within the band in which we try to maintain it. But with the current mortgage rate now much closer to the average note rate of the mortgages in our portfolio, it’s likely that this year we will want to provide for a bit more protection against further interest rate declines, and that means adding somewhat greater amounts of option-based liabilities which have higher initial cost. So for the interest margin, we have a relatively wide purchase spread as a positive and the runoff of low cost debt and the somewhat higher costs of additional option-embedded debt working in the other direction. Adding these factors, you might expect us to show modest declines in our net interest margin of about a basis point a quarter this year.

Credit costs should have little impact on our net income growth one-way or the other. It’s conceivable that our credit costs could fall still further this year. But should the economy soften, it’s also possible that our credit losses may edge up somewhat. If they do, though, it shouldn’t go up by much. The average market value of equity on all the loans we own or guarantee is nearly 40%. We have mortgage insurance on less than 20% initial down payments and mortgage pool insurance on many of the others. And we have exceptional credit loss management capabilities that should prove even more valuable during a downturn than they’ve been during the upswing. Coupled with our disciplined underwriting, the combination of our loss mitigating tools and widespread use of credit enhancements, serves as a highly effective shock absorber for problem credits. Last year the loans we owned or guaranteed produced $435 million in gross credit losses but because of our loss mitigation and credit enhancements, barely a fifth of those losses – just $89 million – ended up being absorbed by us. Credit could be a serious problem for many financial institutions in 2001 but it won’t be a problem for Fannie Mae. As I mentioned earlier, our credit losses in 2000 amounted to only one percent of our total revenues. With those revenues expected to rise at double-digit rate, even a worst-case scenario in our credit situation, which we by no means expect, would barely be noticeable on our bottom line.

So, our business outlook for 2001 seems quite favorable. And we believe our policy and regulatory outlook is equally favorable. Because of the central role we play in the housing finance system, last year questions were raised about the nature of the risks we take and the way in which we manage those risks. We responded to all of those questions comprehensively and substantively. We entered into a series of detailed discussions with a wide range of key policy makers. The culmination of those discussions was the six point voluntary agreement we announced jointly with Freddie Mac last October 19th to enhance our liquidity and disclosure practices and to supplement our capital base. In a press conference with Frank Raines and Leland Brendsel announcing the agreement, Congressman Richard Baker called it “both a high-water mark in corporate responsibility, market transparency, market self-discipline, and proactive protections against potential systemic risk.” And he noted that we had “set the highest and best standards.” He also stated that the agreement would fully satisfy his concerns with respect to the issue of our safety and soundness. Even before that agreement, Fannie Mae was operating under a disciplined, stringent and multi-layered regulatory regime. We are subject to ongoing examinations by a large staff of highly qualified examiners, whose exam results are made public. We have a minimum capital standard which we are held, and we also have a rigorous and path breaking statutory risk-based capital standard which our regulator is currently making final, but which we’ve been adhering to internally since the early 1990’s. Former FDIC Chairman William Seidman called our risk-based capital standards “devastatingly stringent if applied to most other financial institutions.” By design, Fannie Mae is one of the strongest, safest financial institutions in the world. It is entirely appropriate that we should be given our critical position in the U.S. housing finance system and the international capital markets.”

Well, this almost sounds reasonable and believable. But the fact remains that this institution – abusing the marketplace’s acceptance of the implied backing of the U.S. taxpayer – continues an absolutely reckless credit expansion. Representative Baker can back down, Mr. Seidman can utter nonsense, Mr. Howard can obfuscate the facts, and the GSEs can enter into all the voluntary agreements they want, but this doesn’t change the facts. The GSEs become more risky to the U.S. taxpayer and financial system by the day and continue to play a momentous role in an historic bubble that will end in one hell of a mess for everyone.