Last week’s announcement from the Office of Federal Housing Oversight that Fannie Mae had been overstating its annual profits came as no surprise to those of us who’d been tracking the derivative-happy behemoth. However, the likely denouement will play havoc with the bond markets, the housing markets and the U.S. economy.
Fannie Mae’s predicament is an inevitable result of its position as a quasi government guaranteed entity, guaranteeing housing loans and in return receiving an implicit guarantee of the U.S. government, combined with the “anything goes” corporate culture of the 1990s. It is now clear that rewarding management primarily on the basis of short term accounting results, with payouts soaring to gigantic levels if those results exceed targets and drive up the share price, is a recipe for accounting fraud, pure and simple.
In Fannie Mae’s case, the company discovered that its derivatives portfolio, originally acquired in an attempt (in practice, impossible) to hedge the bizarre interest rate risk taken on through trillions of dollars of housing loans, could be valued in a number of different ways, depending on the underlying assumptions made. With some ways producing a steadily increasing stream of profits, the temptation was simple – Fannie Mae accordingly arranged its derivatives portfolio and the accounting thereof to provide the steadily increasing profits record that is so valued on Wall Street.
For many years, this worked well, because of what is now a 23 year period of remarkably favorable conditions in the bond market, if you are in the typical bank (or Fannie Mae) position of holding long term bonds and financing them partly or wholly with short term paper. Long term bond interest rates have been steadily declining since 1981, whereas short term interest rates have, with the notable exception of a brief period of Fed tightening in 1994, been generally below long term rates throughout the period. Consequently banks and Fannie Mae have for 23 years benefited from a positive “carry” in the spread between short term funding and long term investments, and a generally rising trend in the prices of their portfolios of long term bonds. In Fannie Mae’s case, the picture is complicated by their holding of housing debt, which is subject to refinancing if interest rates drop, but the refinancing risk can be taken care of (sort of) by derivative contracts and the interest rate risk can be covered by financing a greater portion of their balance sheet in the short term market.
When the market turns around, bond yields rise and/or short term rates for a prolonged period come to exceed long term rates, this can all go horribly wrong, as was demonstrated by the 1980 failure of the First Pennsylvania Bank. First Pennsylvania was thought to be a very conservative bank; in the 1970s, fearing the effects of recession on its loan portfolio, it had invested a substantial portion of its assets in long term government bonds. Year by year, this was not a problem; in those days the value of the portfolio did not have to be “marked to market” at each year end, and so the gradual erosion of First Pennsylvania’s capital as interest rates rose passed unnoticed by the market. By 1980, the income erosion from the cost of funding being higher than the return on First Pennsylvania’s bonds and the capital erosion from those bonds’ price declines produced a crisis of confidence and the bank’s insolvency.
Derivatives or no derivatives, if interest rates start to rise and short term rates rise above long term rates, the overleveraged Fannie Mae and Freddie Mac are in severe danger of suffering the same fate, at the eventual cost of the unfortunate U.S. taxpayer.
How all this plays out is not at present clear, partly because the bond markets, the stock market and the economy are all going in different directions, thought by conventional economists to be incompatible. Whereas a couple of months ago the threat of inflation seemed to be real, last week bond yields dropped below 4 percent, a level previously seen only in the deflation panic of summer 2003, and commentators reasoned that the bond market was seeing future economic weakness and therefore deflation.
The problem with economic forecasting is econometrics. Economists attempt to measure the economy with equations, then attempt to solve the equations and thereby predict its path. However, economists are not generally very good mathematicians, and therefore tend to simplify reality into a series of linear or exponential equations, the two types they can solve. This is an old trend; Thomas Malthus first made the simplification in 1798, when he famously predicted that exponentially growing population would outrun linearly growing food crops, causing mass starvation. The reality, of course, was that population growth wasn’t exponential, and growth in food crop yields and acreage wasn’t linear, so his prediction was nonsense.
The problem with this simplification is that it leaves out what appears to be the most frequently occurring economic relationship: the power curve, whether quadratic, cubic or of some higher or indeed fractional order. Power curves, beyond the simplest, have an important property that linear and exponential equations don’t exhibit: they can form “catastrophes,” at which their behavior suddenly changes direction altogether, with startling results. Stock market crashes like 1929 or 1987 are the results of such “catastrophes.” They can have fairly clear causes and dramatic consequences, as in 1929, or unclear causes and almost no consequences, as in 1987 – two entirely different results from the same approximate cause, which would be quite impossible in a linear or exponential world.
The U.S. economy is, as frequently detailed in this column and elsewhere, full of imbalances, of stock and housing bubbles, trade deficit, budget deficit, excessive money creation and imbalance between savings and investment. In normal circumstances, the distance between deflation, in which, as in the Japanese 1990s, prices decline and the economy stagnates, and inflation, in which as in the U.S. 1970s prices spiral uncontrollably upwards, is quite large – if you like, the economy moves along a substantial stable plateau between the twin chasms.
Currently, that plateau seems to have narrowed to a rocky mountain path, with precipices on either side. Signs of both deflation (declining bond market yields) and inflation (rising commodity prices) are appearing simultaneously. Conventional economists are right that this cannot last. What we cannot tell (which in any case, because of the “butterfly effect,” by which a tiny change in conditions can at a catastrophe produce a huge change in consequences, may be unknowable) is which side of the mountain we will plunge down when the path gives out altogether.
The bond market is telling us that we are about to hit deflation, a decline in gross domestic product, a long term slackness in the economy like the 1930s, and a lengthy recession. The commodity markets (and to a large extent, the remarkably resilient stock market) is telling us we are about to experience a surge in inflation, which will only be cured by a prolonged period of tight money and stagnation, as in the 1970s. They’re probably not both right, and which one happens may well be effectively random, depending on subtleties in the current position that are too insignificant to measure. Either way, however, it seems likely to happen within the next 6-12 months.
When the “catastrophe” hits, Fannie Mae will make matters substantially worse, as its overleveraged balance sheet and over-aggressive, thoughtless risk management have left it poorly fitted to withstand even the mildest financial storm. If we get deflation, house prices will decline, along with asset prices of all kinds, and Fannie Mae will be faced with a tsunami of bad debts and severe financial difficulties. If we get inflation, bond yields will rise, the Fed will be forced to raise short term rates sharply to kill the inflation, and Fannie Mae will have a strong probability of going the way of the First Pennsylvania Bank. Either way, the taxpayer will be out of pocket in the end.
I have to say, inflation seems a slightly pleasanter fate than deflation, partly because the drop in stock markets, the housing market and other asset markets wouldn’t be anything like as severe. But either way, it will be no fun, and paying large amounts of money to bail out Fannie Mae won’t improve our mood.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.