Are You Missing the Real Estate Boom? (part 2 of 2)

Whiskey & Gunpowder
August 27, 2005
by Mike "Mish" Shedlock
Illinois, U.S.A.

On Aug. 11, 2005, Reuters reported that "Moody's Affirms Fannie Mae "AAA" Senior Debt Rating":

"Moody's Investors Service on Thursday affirmed the 'AAA' senior debt ratings of Fannie Mae, the largest U.S. home finance provider, but said its preferred stock and subordinated debt remain on review for possible downgrade."

I do not know about you, but I do not find it likely that Moody's can possibly know precisely what Fannie Mae's debt rating should be.

I offer the following as proof: Matthew Goldstein on thestreet.com reports "Fannie Restatement Nowhere Near Done":

"The government-sponsored mortgage finance firm says it might not complete the restatement before the second half of 2006. The lengthy delay is just one more indication of the size of the accounting irregularities at the nation's biggest buyer of mortgages.

"'As our normal business operations continue, we also are committing every available resource to the restatement,' said Fannie President and CEO Daniel Mudd. 'This year, we expect that over 30% of our employees will spend over half their time on it, and many more are involved.'

"In fact, the restatement is such a big task, Fannie expects to hire some 1,500 consultants by year's end."

Let's see if I have my facts straight:

1. Fannie Mae's books are so screwed up and they are so late in reporting that there are threats of FNM being delisted.

2. It will take 1,500 consultants to straighten out the derivatives mess.

3. Moody's is willing to affirm FNM's AAA debt rating anyway.

Mish, can Fannie Mae be delisted?

Yes, not only can it, but perhaps it should have already been done. Let's take a look:

"Fannie said the NYSE may start a delisting proceeding when a company fails to file its annual report in a timely manner. Current exchange standards allow the NYSE to continue a listing for nine months from the due date of the financial filing, and for Fannie, that extension ends Dec. 16, the company said.

"The exchange may opt to extend the listing for another three months, according to Fannie.

"Still, Fannie Mae said it was unlikely to report any results before the second half of 2006."

Please bear in mind that even though Fannie Mae can and possibly should be delisted, I seriously doubt that it will be. A lot of mutual funds would have had to dump amazingly large holdings of Fannie Mae if it was delisted. They would not be happy about it either. Is it remotely possible this at all influenced Moody's decision?

Obviously, no progress has been made since then. Perhaps the ratings agencies will not care unless and until they are slapped with a thousand lawsuits. Forget the lawsuits, change the law so that confidence in the system is restored, and rating agencies have a NEGATIVE incentive to play games. Do that, and the credibility problem vanishes instantly. Given how totally messed up legislation is these days, I fully expect to see dozens of "oversight committees," rather than a correction of the basic problem of ensuring that there are no relationships between rating companies and the companies they rate.

For argument's sake, however, let's give Moody's the benefit of the doubt and assume that everything is fine for now and there are no new surprises forthcoming in Fannie Mae's books if and when they are every completed. Are we off the hook?

I think not. Regardless of whether or not something is wrong with Fannie's books, given all of the appraisal fraud, no-doc loans, 0% down loans, piggyback loans, and negative amortization loans, people still better be well prepared for a huge credit implosion when this mess blows up. In the meantime, party on, dudes, as banks and other mortgage originators attempt to keep the good loans on their books but pass the trash on to Fannie Mae or someone else. That garbage is ending up in state pension plans, other retirement plans, and in the hands of hedge funds and others that probably have no idea just how toxic it is. In the meantime, the sheep are grazing, and perhaps a blatant attempt is being purposely made to spread the Fannie Mae risk around enough so that no single entity gets wiped out by it all.

Let's take a look at one more thing. Please listen to at least the last 15 minutes of the Saxon Capital, Inc. Earnings Conference Call (Q2 2005).

Given that some of you are simply too time pressed to do that, following is a brief transcription of the highlights.

Starting about 43:10 minutes in, Saxon states:

** Too much risk-taking will lead to a "credit event"

** Much of the volume of competitors is refinancing customers from one product to another to another to another

** If you are going to be competitive in the business, you HAVE to have a product basket that the customer is demanding and the market is willing to provide

** Offering these products will allow us back into these markets

** "At the point in time WHEN the credit event comes, AND IT WILL, we will be very well placed to take advantage of what happens next"

** "I am concerned about the level of capital" of our competitors "to service the bonds as those portfolios age"

** "Should real estate on the West Coast flatten out, I would be worried about a credit event"

With that thought in mind, please remember the "Big Three" failed to see LTCM coming, failed to see Enron coming, failed to see Tyco coming, failed to see WorldCom coming, etc. Clearly, something is wrong somewhere. What is it? Is it because of relationships that the Big Three maintain with the customers they rate, is it just plain bad luck, or is it something else?

At any rate, how can anyone possibly know what is in those books if it takes 1,500 consultants working for a year to straighten them out? I contend that no one can possibly know what the bottom line result of that audit will be. If one does not know what is in the books, the next logical question is how can it be possible to affirm a top rating on that company's debt? Hmmm...the questions keep coming. Going one step further, does anyone even care what is in the books? The final question along that line is even if someone does care, are they just hoping that nothing bad comes up, knowing they have a fallback excuse of, "We did not know what was in the books"?

Clearly, we need to remove all such doubts if credibility on debt ratings is to be truly restored. That means that all rating companies need to be completely independent of outside relationships with companies that they rate. It also means that companies should be competing for business solely on the accuracy of their ratings, not on anything else. I have a strong suspicion that we would have seen WorldCom, Enron, and Tyco all downgraded far earlier if accuracy was what mattered most.

Part of the problem lies in the fact that billions of dollars change hands when there are even small changes in debt ratings. A downgrade to junk (as with GM recently) can have a severe impact. It almost seems as if everyone has to firmly expect it before it happens. Nudge, nudge, wink, wink. On unexpected unfavorable ratings, business relationships will be stressed. The solution is not more "oversight" committees or more accusations and subsequent denials from the Big Three that they are not at fault. We need to remove suspicion of fault, and the only way to do that is for outside relationships to be made illegal.

Back in February, The New York Times said, in "Wanted: Credit Ratings. Objective Ones, Please":

"'I think it's fair to say that the oversight of the industry is insufficient,' said Annette L. Nazareth, director of market regulation at the Securities and Exchange Commission. 'We want the firms to commit to meet certain standards with respect to policies and procedures on conflicts of interest and solicitation of ratings. Right now we don't have that at all.'"

Obviously, no progress has been made since then. Perhaps the ratings agencies will not care unless and until they are slapped with a thousand lawsuits. Forget the lawsuits, change the law so that confidence in the system is restored, and rating agencies have a NEGATIVE incentive to play games. Do that, and the credibility problem vanishes instantly. Given how totally messed up legislation is these days, I fully expect to see dozens of "oversight committees," rather than a correction of the basic problem of ensuring that there are no relationships between rating companies and the companies they rate.

For argument's sake, however, let's give Moody's the benefit of the doubt and assume that everything is fine for now and there are no new surprises forthcoming in Fannie Mae's books if and when they are every completed. Are we off the hook?

I think not. Regardless of whether or not something is wrong with Fannie's books, given all of the appraisal fraud, no-doc loans, 0% down loans, piggyback loans, and negative amortization loans, people still better be well prepared for a huge credit implosion when this mess blows up. In the meantime, party on, dudes, as banks and other mortgage originators attempt to keep the good loans on their books but pass the trash on to Fannie Mae or someone else. That garbage is ending up in state pension plans, other retirement plans, and in the hands of hedge funds and others that probably have no idea just how toxic it is. In the meantime, the sheep are grazing, and perhaps a blatant attempt is being purposely made to spread the Fannie Mae risk around enough so that no single entity gets wiped out by it all.

Let's take a look at one more thing. Please listen to at least the last 15 minutes of the Saxon Capital, Inc. Earnings Conference Call (Q2 2005).

Given that some of you are simply too time pressed to do that, following is a brief transcription of the highlights.

Starting about 43:10 minutes in, Saxon states:

** Too much risk-taking will lead to a "credit event"

** Much of the volume of competitors is refinancing customers from one product to another to another to another

** If you are going to be competitive in the business, you HAVE to have a product basket that the customer is demanding and the market is willing to provide

** Offering these products will allow us back into these markets

** "At the point in time WHEN the credit event comes, AND IT WILL, we will be very well placed to take advantage of what happens next"

** "I am concerned about the level of capital" of our competitors "to service the bonds as those portfolios age"

** "Should real estate on the West Coast flatten out, I would be worried about a credit event"

** "There are people that will buy a 100% loan to value (LTV). We do not have that product, we do not believe in it. We want the stated income borrower to actually have some skin in the game"

** We can now offer those products but, "We have no intentions of putting those loans in our portfolio....We are going to pass them through to other investors"

** Question: And you think that is a good strategy -- thinking this is The Perfect Storm you are describing?

** Answer: "As long as the market is willing to provide that credit...they attempt to deliver the customer as much cash as possible with the least amount of investigation or effort....That's what drives our customer....In order to get the customers we want, we need to be able to offer those products"

** Question: "Since I have known you, you have been bearish on the industry...now you are saying, 'I want to be more like people offering products that are unsustainable.' I am struggling with that"

** Answer: "The only difference is that I do not intend to put those in my portfolio...and the day that I can't sell these (to someone else) is the day that I stop offering them."

If lender conference calls are routinely discussing "Credit Events" and "Perfect Storms" and companies such as Saxon are only willing to take on loans as long as they can pass the trash to Fannie Mae or someone else, exactly what confidence should there be in

** Fannie Mae

** The system in general

** Financial institutions specifically

** The Big Three credit rating companies

** What the pundits are saying about housing

** What the administration is saying about the recovery?

Right now, the questions Mish is asking are as follows:

1. How long will it be before we see genuine reform of the credit rating companies?

2. How long will mortgage originators willfully and knowingly take total garbage just because they can pass the trash on to others?

3. With horror stories like I presented earlier, is there any boom left in real estate, other than a loud popping of the bubble?

4. How many lawsuits will eventually be filed by people losing their homes?

5. What will the ultimate cost to taxpayers be for the upcoming credit implosion and subsequent bailout of the credit industry?

Regards,

Aug 23, 2005
Mike Shedlock "Mish"
email: Mish

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