The Half-Life of Fannie Mae and Freddie Mac

If the post Bear Stearns bailout can last nine weeks, the Fannie Mae and Freddie Mac bailout rally is likely to be shorter than that. It remains uncertain if it represents a definitive bottom for financial risks. According to Moody’s, the global issuer-weighted speculative default rate rose 20bps to 2.65% in August, an increase from 2.45% in the prior month and up 121bps since the same month last year. This is the ninth consecutive monthly increase in the global speculative grade default rate and the rating agency now forecasts a 4.9% default rate by the end of this year.

The injection by the Treasury of up to US$100bn each into Fannie and Freddie is one more signals that the US is taking the same path trodden by Japan in the 1990s. And it would not be surprised, if the Feds to own more than 60% of the US mortgage market within just few years. Fannie and Freddie produce the credit growth and Treasury buys their mortgage backed securities (MBS) so that they can create even more. This in turn, will raise the risk in Treasury yields as the Treasury will need to issue more debts. If I am right, I could be damn right because as the yield curve is upward shifting, commercial credit defaults will rise rapidly and bad debts will increase in accordance, and this is exactly how the powers of creative destruction will eventually come back to US.

According to some estimates that come to my attention, it will take about another 2 ½ years to absorb the excess housing inventory. House prices may need to adjust another 12-15% before housing affordability to make it attractive. In my own opinion, the de-leveraging process has hardly started in the US. The US consumer debt relative to assets is at an all time high, of around 21% versus an average of 15% in the early part of 1990s. One should not forget that bulk of 1H US growth this year came from tax cuts and net exports.

Based on these observations, the S&P 500 is facing a downside risk of 5.5-10.1% from current 1,267. Corporate earnings are still 8% above trend in the US and almost double in the case of Europe. Usually, earnings typically trough around 155 below trend and majority of time, equities do not trough until earnings are below trend.

In essence, I remain conservative because of the high inventory of unsold houses, large delinquency pipelines, fairly tight underwriting standards, and weak macroeconomic fundamentals related to the health of the consumer.

I think the dollar has large net long speculative positions and remain a net seller in current rally.