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This is a follow up to my last article, Subprime
Mortgages Lead to Subprime Currency, in which I
wrote:
The
curious mind asks, who holds those $trillions worth of mortgages? Thanks
to the genius of the American banking and marketing machine, just about every
sizable institution underneath the sun with a fixed income portfolio. From
Europeans to Asians, from Banks to Brokerages, from Hedge Funds to Pension
Funds, Institution to Retail, Trusts to Endowments.
Most
of those aforementioned outfits are in a state of shock and have been
reluctant to mark their $trillion+ subprime
portfolio to market. Every other day there is new revelation of substantial subprime loss. First it was New Century in March, then
American Mortgage and Countrywide in September, then it got worse as Wells
Fargo, Bank of America, Credit Suisse First Boston, Citibank (albeit with a
new CEO now) came out of woodworks. Last Friday it was Wachovia (US 4th
largest), and on Tuesday it was Etrade. Not one
major bank dealing with mortgages was immune. If there is such thing as
systematic risk, we are sure looking at one, and therefore expect a lot more
skeletons to come out of the closet in the months to come.
In two short weeks, HSBC (HBC), Citibank (C), Goldman Sachs (GS), Swiss Re (SWECY.PK), and
Japanese outfits have revealed tens of billions of losses stemming from US
mortgages.
I also said:
At this juncture, the Fed has no choice but to redeem any and all
mortgages at near face value directly, through GSE, or offshore vehicles. The
more the Fed redeems, the more dollars they print. When
you print $1 trillion (10%) a year, people can reasonably swallow the extra
money supply, but when you print a $1trillion in a hurry and in a conspicuous
way, you are directly challenging money managers’ intelligence and you
will see a squeeze in gold. It’s that simple.
CNNF kindly explains how GSE’s work and their impending failure.
Fannie Mae guarantees mortgages, which have been packaged and sold to
investors as bonds. If a homeowner falls significantly behind on his
payments, Fannie Mae has to buy back the loan from the bondholder. If the
mortgage has an outstanding amount of, say, $100,000 and unpaid interest of
$5,000, Fannie Mae would have to pay $105,000 -- its full value -- to make
the bondholders whole. However, the $105,000 loan may actually be worth less
on the market. It is Fannie Mae's job to estimate the market value, or fair
market value, of the loan and to record that price on its books. So if the
fair market value is $80,000, Fannie Mae takes a loss of $25,000 (the
difference between $105,000 and $80,000). That loss is considered an SOP 03-3
loss -- so named after the applicable accounting rule.
Until recently, Fannie Mae included SOP 03-3 losses as part of its
credit-loss ratio. But here's the trick: Fannie insists that, based on past
trends, it can recover a large part of that $25,000 loss by, for example,
helping the borrower renew payments. So it simply decided to stop including
SOP 03-3 losses in calculating its credit-loss ratio.
Fannie Mae's decision to exclude SOP 03-3 losses coincide with their
shocking rise: In the third-quarter ended Sept. 30, 2007, the company's SOP
03-3 losses came to $670 million, up from $37 million in the same period a
year ago. It's not clear why SOP 03-3 losses are skyrocketing, but it
suggests that Fannie Mae is having credit problems and is having to buy a lot
more bad loans back from bondholders.
The reason for the dramatic
SOP 03-3 rise is very clear according to the ABX index below.
The index shows
collectively, that mortgages GSE’s (Fannie (FNM) and Freddie (FRE)) guarantee are selling at
.70 cents on the dollar. Freddie's $120 billion and Fannie’s $42
billion of exposure to GSE-qualified mortgages means a write-down of over $30
billion and $10 billion respectively. Given that both outfits have about $1
billion in excess capital, they are now technically insolvent, especially
when the ABX index is showing no signs of reversing. Freddie has hired
Goldman Sachs and Lehman Brothers as advisors to help it raise capital in the
very near term, but our take is that no sane institution will lend money to
Freddie. If left to their own devises by the government, Fannie and Freddie
are doomed.
In our last article I also
said:
No sane foreign institution is going to finance American home owners,
and why should they when they can finance the Brazilians, Canadians, Thais,
Russians, Chinese, Indians, with an appreciating currency? The dollar reserve
status is now shattered. Mind you, it’s not that we are against the
dollar in particular, we just don’t think any
fiat currency deserves to be the world’s reserve currency.
To those who say gold is due for a pro-longed correction at $800, they
are missing the big picture. To us gold’s run has just gotten started,
the Emperor is now naked for all to see.
Not only are
mortgage-backed securities distressed, but auto-loan
backed securities and credit-backed securities are now beginning to
experience pressure. The world had a love affair with the Dollar, and happily
ate up any Dollar-denominated package that threw a 5% interest at them. This
$30 trillion+ affair has ended and the aftermath is
not pretty. To understand why the Fed has to print and bail out all those
banks and funds, we highly recommend that you watch this British comic
strip.
From the banker:
One thing I learned is if you are going to cock up something, better
cock up big so government has to bail you out, and if the government does not
give me my money back, I will tell them, it’s not my money, its your
pension fund money.
Technically gold has just
successfully tested the 50 day-moving-average support. Our 2007 target of
$850 for gold may be too conservative, as once the $850 level is overcome,
gold could rapidly challenge the $1,000 level. Welcome
to inflation and welcome to gold.
By :
John Lee, CFA
Goldmau.com
John Lee is a portfolio manager at
Mau Capital Management. He is a
CFA charter holder and has degrees in Economics and Engineering from Rice University.
He previously studied under Mr. James Turk, a renowned authority
on the gold market, and is specialized in investing in junior gold and resource
companies. Mr. Lee's articles are frequently cited at major resource websites
and a esteemed speaker at several major resource
conferences.
Please visit www.GoldMau for instant market alerts and stock updates.
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