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Stock Ideas Investors Daily Edge Freddie and Fannie’s bonds A $10 Trillion Problem
Stock Ideas Investors Daily Edge Freddie and Fannie’s bonds A $10 Trillion Problem 
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Dear Reader, A few weeks ago, I asked you to give me a story about what the government did to piss you off. I got a lot of feedback. Apparently the government is good at pissing everyone off! |
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| Freddie and Fannie’s bonds A $10 Trillion Problem |
| Friday, 12 September 2008 | ||||||||
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Remember when you were a little kid and being handed a dollar seemed like you had just hit the lottery? I’m reminded of it every time I give a dollar to my four-year old niece, Amanda. Her eyes light up and she gets the biggest smile in the world. Then she looks at me, hugs me and says, “I love you, Charlie!” If I give that dollar to my girlfriend’s 11-year old brother, then he does a little dance and sings “Million dollar baby!” (Side note: If everyone reacted like that when money was given to them, maybe more people would hand out money!) If I were to show them a hundred dollars, they might pass out. But is a hundred dollars really that much? Not in the financial markets. A hundred dollars doesn’t even get you a share of Google stock. Truthfully, even a few billion dollars doesn’t seem like much anymore. One day you’ll hear about an $8 billion fund going under. Yet, if it’s a mutual fund or hedge fund that loses the $8 billion, then it doesn’t seem like much. After all, some funds have in excess of $100 billion in assets. Freddie and Fannie both control nearly half of a $12 trillion mortgage market. Suddenly, even $80 billion seems like a pittance. Ah, if that were all… Since so many big banks are holding Freddie and Fannie’s bonds, they have an interest in protecting their holdings as much as possible. They did it by buying credit default swaps in the derivatives market. A credit default swap is like a put option. The seller of the swap gives the buyer the right to sell the bonds they hold at a predetermined amount to the seller in the case of a default. The buyer of the swap then pays the seller a certain amount every six months to keep the contract current.
Well, $1.6 trillion in default swaps were triggered when Fannie and Freddie were put into conservatorship. This will be the biggest payment ever made in the derivatives market. And even though sellers of these swaps probably won’t lose much money, it’s still a huge strain on the financial system. Now, just imagine $1.6 trillion in bonds moving from one party to another. Talk about a huge shift in assets… Yet, this is still nothing. China has currency reserves approaching $2 trillion. The FOREX market has about $4 trillion flowing through it. The US GDP hovers around $13 trillion. Global GDP is a little over $54 trillion. Eh, that’s still not that much money. Want to see a big sum of money? The global derivatives market is worth about $516 trillion. With sums that large, it’s hard to feel moved by $500 billion in bank losses. Yet I’m still amazed when people assume that we might only lose $500 - $600 billion. The mortgage market is worth about $12 trillion. Consumer Credit in the US alone is about $2.59 trillion. So far, the losses we’ve seen are only 3.4 percent of the consumer credit and mortgage credit available. Do you think the biggest real estate slowdown we’ve ever seen… combined with the biggest bailouts the government has ever made… will only create losses of 3.4 percent of the total mortgage and consumer credit out there? Not a chance. Losses will grow as more people miss their mortgage payments. Defaults will grow as credit card debt overwhelms people who just lost their jobs. Defaults will grow as more banks, mutual funds, and hedge funds fail. This doesn’t even account for the losses both Fannie and Freddie will accrue while under government ‘conservatorship’. The government has promised to infuse a combined $200 billion into these companies should they need it. And that doesn’t include the $2 billion in preferred shares that the government bought. You can be sure that if they need even more money, the government will give it to them because they now have a vested interest in not allowing these institutions to fail. In all, the government wants you to believe that a portfolio of over $5 trillion mortgages, in the midst of the worst real estate slowdown since the great depression, will only lose $200 billion. That’s less than five percent. Does Uncle Sam think we’re fools? This is what we’re dealing with: One of Washington Mutual’s Alt-A (no doc loans) mortgage pools (WMALT 2007-0C1) is showing 25 percent of its mortgages as 60 days late, and 13 percent of them are in foreclosure. This pool was originally rated AAA, but looking at its condition right now, you’d have never guessed it. Defaults on credit cards are rising. Defaults on mortgages (all types, even prime) continue to rise. Commercial property defaults are moving higher. Corporations are maxing out their credit lines, and corporate defaults are picking up. It doesn’t sound like an end is near for credit losses. You should expect them to rise well over $1 trillion. They could hit $2 trillion or more by the time all is said and done. Of course, what isn’t mentioned is how all of this credit was leveraged. If we are conservative and estimate that this credit was leveraged by five times, then a $1 trillion credit loss turns into a $5 trillion liquidity loss. A $2 trillion loss becomes a $10 trillion liquidity loss. $10 trillion is only $3 trillion shy of being as large as the US GDP. You can imagine the effect that type of loss would have on the global economy. Actually, you don’t have to imagine too much, because it’s going on right before your very eyes. This deleveraging could turn out to be one of the biggest deflationary events since the Great Depression. So I hope you are prepared for it. Financials will continue to get slammed in the meantime. Commodities won’t have the same ‘fire’ we saw over the past few years. And debt-heavy corporations will find it harder to roll over their bonds. I wish I could give you the answer du jour – to buy gold and silver. But gold and silver don’t do well in deflationary environments. So I expect them to underperform over the next twelve months. The truth is, picking stocks in this environment is going to be rather difficult. As money disappears from the credit markets, the deleveraging it causes will bring down the overall value of stocks, commodities, and real estate. My only recommendation to you is to begin looking into bonds. Because very strong companies have bond yields that boggle the mind. I’m talking about eight to nine percent in interest alone. In a market where most assets are falling, the corporate bond market is one of the safest places to put your money. Luckily enough, we found a way to get you names of very high-quality bonds, with above-average yields, and very little interest rate or default risk. Just go here to find out how to get more information absolutely free. Stay free, Charles P.S. To let me know what you thought of today's article, send an e-mail to: This e-mail address is being protected from spam bots, you need JavaScript enabled to view it
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