Sarasota and Fannie Mae Reform

Sarasota and Fannie Mae December 12, 2009   David Kotok, Chairman & Chief Investment Officer

We are writing this from Sarasota on Saturday afternoon.  It’s 77 degrees with a Gulf breeze; the rain and fog are gone.   Setting up the new Sarasota office is underway.  We expect it will be functional and integrated with the Vineland office in January.  

Here in Sarasota, the local paper is full of mini-Madoff stories and a reference to the big one.  There is an auction tomorrow of Madoff stuff at the Ritz Carlton.  The home grown local versions of Bernie are measured in millions and not in billions.  They contain names like Arthur Nadel, John & Marian Morgan and Beau Diamond.  Sarasota has had its share of scam artists.

One type of Ponzi scheme didn’t make the front page of the local paper.  That is because it isn’t criminal.  It is a gift from the same Congress that just witnessed the House passing the financial reform bill.   That gift is Fannie Mae and Freddie Mac. 

In a superb piece of December 11 research, Barclays Capital has discussed the forthcoming expiration of certain components of the assistance that Fannie and Freddie are getting from the Treasury.   Several components will be expiring or will need reauthorization by Congress.  

The key area is in the enabling of the Treasury to support the equity stake in Fannie with use of the Preferred Stock Purchase Option. (PSPA).  Barclays notes the following when it comes to their review of the $400 billion Treasury has committed:

“In retrospect, the PSPAs should never have been equally sized, in light of the fact that FNM’s credit book is more than 50% larger than FRE’s.  In the spirit of providing investors with a comfort under a tail scenario that triggers GSE receivership, we believe that Treasury should increase the preferred backstop available to $300bn before year-end.”  Note that after yearend no increases can be made without congressional approval.

Barclays also notes the requirements for the GSEs to start shrinking their portfolios in 2010 and that the GSEs have been slow to buy out existing delinquencies from pools.   The combination of all the elements suggests that there are many billions of losses still to be revealed in the saga of the GSEs.  

Many say, and we agree, that it is time to end this fiction of an implied guarantee and for the Treasury to take the GSE debt onto its balance sheet. Everyone assumes the US will not permit a default of a GSE on its debt even if it goes into a receivership.  And most observers realize that the housing recovery now depends on federal mortgage credit flowing to home purchasers.  

But there is another collision course under way in the Washington.   The debate over the debt ceiling is already testy and that is before any authorization to formally take GSE debt on the balance sheet of the United States.  Officials mostly say that the nationalization of the GSEs is likely to occur and that timing is the issue.   Welcome to the world of politics. 

So, we thank the House of Representatives for giving us a financial reform bill that was silent on the housing financing/GSE issues.  Meanwhile, GSE debt seems to trade at a tight spread and the Fed purchase program continues until March.  After that, nobody knows where GSE debt yields will go.   Remember this: if they go higher and spreads widen, the marginal house buyer is put out of action. Housing recovery depends on house prices falling or stabilizing and on mortgage availability for the new buyer.  The former is likely to continue for a while.   The latter may be in jeopardy because of politics.

In Florida we see housing trading hands at half the price level of 4 and 5 years ago.   Several Cumberland folks have purchased homes at prices they previously didn’t think possible.  If mortgage financing remains available, this market will start to clear and gradually stabilize.  The same will be true throughout the country where the price level of housing has fallen to levels that can be supported by the GSE limits.   Higher priced houses with jumbo mortgages are another issue.  

Stay tuned as we watch the GSE theatre unfold in 2010.

Cumberland AdvisorsSM is registered with the SEC under the Investment Advisors Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in states and/or international jurisdictions where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services.

Please feel free to forward our commentaries (with proper attribution) to others who may be interested.

For a list of all equity recommendations for the past year, please contact Therese Pantalione at 856-692-6690,ext. 315. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.