Sarasota and Fannie Mae

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).


December 12, 2009

We are writing this from Sarasota on Saturday afternoon. It’s 77 degrees with a Gulf breeze; the rain and fog are gone. Setting up the new Sarasota office is underway. We expect it will be functional and integrated with the Vineland office in January.

Here in Sarasota, the local paper is full of mini-Madoff stories and a reference to the big one. There is an auction tomorrow of Madoff stuff at the Ritz Carleton. The home grown local versions of Bernie are measured in millions and not in billions. They contain names like Arthur Nadel, John & Marian Morgan and Beau Diamond. Sarasota has had its share of scam artists.

One type of Ponzi scheme didn’t make the front page of the local paper. That is because it isn’t criminal. It is a gift from the same Congress that just witnessed the House passing the financial reform bill. That gift is Fannie Mae and Freddie Mac.

In a superb piece of December 11 research Barclays Capital has discussed the forthcoming expiration of certain components of the assistance that Fannie and Freddie are getting from the Treasury. Several components will be expiring or will need reauthorization by Congress.

The key area is in the enabling of the Treasury to support the equity stake in Fannie with use of the Preferred Stock Purchase Option. (PSPA). Barclays notes the following when it comes to their review of the $400 billion Treasury has committed:

“In retrospect, the PSPAs should never have been equally sized, in light of the fact that FNM’s credit book is more than 50% larger than FRE’s. In the spirit of providing investors with a comfort under a tail scenario that triggers GSE receivership, we believe that Treasury should increase the preferred backstop available to $300bn before year-end.” Note that after yearend no increases can be made without congressional approval.

Barclays also notes the requirements for the GSEs to start shrinking their portfolios in 2010 and that the GSEs have been slow to buy out existing delinquencies from pools. The combination of all the elements suggests that there are many billions of losses still to be revealed in the saga of the GSEs.

Many say, and we agree, that it is time to end this fiction of an implied guarantee and for the Treasury to take the GSE debt onto its balance sheet. Everyone assumes the US will not permit a default of a GSE on its debt even if it goes into a receivership. And most observers realize that the housing recovery now depends on federal mortgage credit flowing to home purchasers.

But there is another collision course under way in the Washington. The debate over the debt ceiling is already testy and that is before any authorization to formally take GSE debt on the balance sheet of the United States. Officials mostly say that the nationalization of the GSEs is likely to occur and that timing is the issue. Welcome to the world of politics.

So, we thank the House of Representatives for giving us a financial reform bill that was silent on the housing financing/GSE issues. Meanwhile, GSE debt seems to trade at a tight spread and the Fed purchase program continues until March. After that, no body knows where GSE debt yields will go. Remember this: if they go higher and spreads widen, the marginal house buyer is put out of action. Housing recovery depends on house prices falling or stabilizing and on mortgage availability for the new buyer. The former is likely to continue for a while. The latter may be in jeopardy because of politics.

In Florida we see housing trading hands at half the price level of 4 and 5 years ago. Several Cumberland folks have purchased homes at prices they previously didn’t think possible. If mortgage financing remains available, this market will start to clear and gradually stabilize. The same will be true throughout the country where the price level of housing has fallen to levels that can be supported by the GSE limits. Higher priced houses with jumbo mortgages are another issue.

Stay tuned as we watch the GSE theatre unfold in 2010.

David R. Kotok, Chairman and Chief Investment Officer, email:

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