Exposure to MBS

[powayseller]

How many of us, unknowingly, have retirement or pension fund money invested in Fannie Mae or Freddie Mac, also known as GSEs (government sponsored enterprises)? As housing bears, we need to consider the risk to these institutions if the housing market is adversely impacted on a large scale.

Fannie Mae has not filed an accounting statement with the SEC in 2 years, has acknowledged they overstated earnings by at least $11 billion, and has a ton of accountants trying to figure out what really happened. They estimate that 30% of their employees, along with 1500 consultants, will spend the next year on this, for a total of 6 – 8 million labor hours!

Unexpectedly, the CFO of Freddie Mac, Martin Baumann, resigned this week.

Treasury Secretary John Snow said that “More than six out of ten institutions in the banking industry hold as assets GSE debt in excess of 50 percent of their capital”, and “The GSEs hold less than one-half the capital of similarly sized financial institutions.”, so they are overleveraged.

Alan Greenspan stated a couple years ago that problems at Fannie and Freddie poses a risk to the global financial system. The risk is caused by the large amount of debt they hold (their bonds), which have been issued to increase investor profits. Mr. Greenspan is a conservative and cryptic speaker, so plain language like this, from him, is concerning.

I checked with Vanguard, to see if my Prime Money Market fund includes any holdings in GSEs, and which fund excludes these purchases. I’m assuming all money market funds hold similar instruments. Here is Vanguard’s reply:

“Vanguard Treasury bond funds are the only bond funds in which you would not find Government sponsored enterprise holdings. There are no other funds that have a guarantee to exclude these securities from the portfolio.”

From their Prime Money Market Fund prospectus: “At least 80% of the Fund’s assets are invested in securities issued by the US government and its agencies and instrumentalities. Although these securities are high quality, most of the securities held by the Fund are neither guaranteed by the U.S. Treasury nor supported by the full faith and credit of the U.S. government.”

I wonder if anyone else has been concerned about this. I wonder what the government would do if one of the GSEs lost money. What would this do to our retirement savings? Is anyone else thinking of bailing out of money markets?

[privatebanker]

You bring up a good point. Many of the portfolio managers for these funds use derivative strategies to limit risk. Through the use of credit default swaps, in theory, should protect a debt instrument from losing value. I do not believe that they’ve been fully tested in a real panic situation though. As for money funds, the risk is far less than just an average bond fund because of the extremly short duration and maturity time frame usually up to 60 days. Also, money managers are acknowledging the fact of a possible MBS meltdown and should be watching this market very closely. This is one of those things (MBS market) that we haven’t really seen before. Maybe the “Plunge Protection Team” will do their manipulation if things got real ugly!

http://www.theprivatebanker.blogspot.com/

[privatebanker]

Here’s another interesting fact regarding MBS per PIMCO:
“MBS are the Largest Segment of the U.S. Bond Market
With $5.6 trillion in mortgage-related debt outstanding as of June 30, 2005, mortgages are the largest segment of the U.S. bond market, accounting for 22.9% of all bond market debt outstanding, according to estimates by the Bond Market Association. For comparison, corporate bonds account for 20.4% of the market, and Treasury debt accounts for another 16.3%.”

“Mortgages are also among the most actively traded securities in the U.S. bond market. Primary dealers-the large banks authorized to deal directly with the Federal Reserve-traded on average more than $260 billion per day of agency MBS in 2005, according to data from the Bond Market Association and New York Federal Reserve Bank. For comparison, primary dealers traded about $20 billion per day of corporate bonds with maturities of more than one year in 2005.”

I’d be curious to see how this changes going forward.

http://www.theprivatebanker.blogspot.com/

[powayseller]

Where is a safe place to put money then? I was thinking of government Tbills or Tbonds, through a Vanguard account. I’m leery of gold, but if 4plexowner can convince me otherwise, I’m open to putting some money there.

I still haven’t heard a good argument for buying gold, and whenever I post a question regarding how we would end up paying each other in gold, the poster mysteriously disappears.

It’s obvious they’ve not thought through how realistic the “gold is the only store of value and real money” argument is.

Warren Buffet is betting against the dollar by doing currency bets of some sort. He lost last year, as the dollar didn’t drop as he expected. Perhaps we should keep some savings in euros.

The next few years are delicate. It’s not certain how long the economy will remain resilient in the face of this housing and debt bubble. I’m considering moving from index funds, money market and stay in CDs, treasury bills/bonds, perhaps euros, perhaps more Berkshire Hathaway stock. I’m looking for some feedback here.

[RightSide]

I recommend for you TIPS they are Treasury Inflation Protected Securities and backed by the US Government. They are also a favorite recommendation by Bill Gross, head of PIMCO (the world’s largest bond fund company).

They pay a slightly smaller yield then a regular treasury bill, but the principal repayment is indexed to the inflation rate.

YOU ARE GUARANTEED a REAL RETURN on these T-Bills!

There is not a safer investment in this market environment.

I think Berkshire Hathaway is probably a great investment. He is well hedged against the dollar, has a ton of cash-flow generating assets that will hold their value no matter what the market does.

Go 50% TIPS, 25% Berkshire, and 25% a global world index fund and you should be good to go.

For myself, I like to speculate in numerous markets. I use exotic non-directonal option strategies for income, a market neutral us portfolio for core holdings, and I play with distressed debts and microcaps with about 25% of my portfolio. I also do some angel investing and private equity, but have not had any big winners yet…

I do plan to actively speculate on the housing futures market if it garners enough liquidity to trade. Its supposed to launch next quarter. I also think stocks like LEND will go OUT of business if their is a major housing crash.

[barnaby33]

How did MBS’s become the largest component of bonds so quickly? It seems like in the last year or so there has been alot of talk about them and their potential effects on our economy, but haven’t they existed for quite some time? I realize that the great American equity cash-out of the last few years greatly increased the amount of MBS, but where did it all begin?

Josh

[NotARocketScientist]

Your posts on this subject are a warning light on the dashboard of my investment strategy.

In ’97-98 my wife and I saw the bottom of the last RE cycle but didn’t feel we had the financial wherewithal to invest quite yet. Our solution was to aggressively earn more and save more by working longer hours and deferring gratification. We parked the loot in CDs because with low inflation we were more interested in security than high yields.

We expected to see RE prices peak out by ’04 and thought by ’06 we’d be tracking the slow, sticky ride to the bottom of the market and investment time.

Instead, buyers downed a a few thousand fistfuls of low-interest ARM steroids and went crazy.

No problem, we thought, it buys us a few more years to save capital to invest when the time is right. Cash will be king when the low-interest hangover starts hitting the markets. A winning strategy.

But now you raise a much more fundamental question: if the financial structure takes a big enough hit from deflation, overleveraged debt, recession, insolvent retirement funds, shady accounting, etc., how and where do you preserve capital?

Can a government that is committed to funding an expensive war, preserving tax cuts, maintaining Social Security, bailing out insolvent retirement plans, etc., find the money to cover my little FDIC insured investments? Should I convert to T-bills? Bury gold in my backyard?

Dunno.

I’m certainly not convinced that the worst scenario is actually going to happen, but I am convinced that it could happen. Which means we’re all working without a net here. I’d certainly like to see other posts from people trying to figure out how to preserve capital.

We live in interesting times.

[NotARocketScientist]

I will look into TIPS. Thanks, RightSide.

[powayseller]

I am not concerned about the government defaulting on its debt. They’ll print more money if they need to.

People have become complacent with bonds, as times have been good for so long.

I think that anyone counting on their pension funds is in for a rude awakening. The government cannot possibly bail out every pension fund. The amount of money they would have to print would devalue the dollar.

I like the recommendation made by RightSide. TIPS (in Vanguard fund), Berkshire Hathaway (to get equity exposure), and a global index fund. I will check into these. The US stock market is trading at a very high multiple of earnings, and at some point, will need a correction too.

As far as gold, I’m still waiting for 4plexowner to finish our dialogue, and to convince me that gold is a viable store of value and trade. Until then, I’m not buying any gold. Did you know that the majority of demand of gold is by jewelers? What happens during the next recession, when people cut back on their jewelry purchases? Gold will decline, right? People are not buying gold as a store of value, but rather for speculation and jewelry.

[davelj]

TIPs are not a good idea in my opinion because they track changes in the CPI, which is a sham of an index calculated by the government. For the last several years, economist John Williams has been re-calculating the CPI using the early-80s methodology – in other words, not using the imputed rents, substitution effects and hedonic adjustments that have been instituted into the CPI methodology over the last twenty years – and has found that using the original (“real”) methodology inflation has been running in the 5%-6% range for many years now. This also conveniently explains how reported CPI inflation can come in at 3% over several years while the money supply has been expanding at more than twice that rate – because the CPI is government fraud! Recall that with hundreds of billions of dollars in government payments tied to the CPI it’s in the government’s best interest to keep the reported number as low as possible. Each percentage point increase would increase government outlays by billions of dollars per year. I’m not a conspiracy theorist by nature, but the CPI calculation is a total and complete fraud used to placate the masses.

Personally I’m not much into negative real rates of return on my investments. But, if you still like those TIPs, by all means… dig in.

[davelj]

Here’s the link to Williams’ work…

http://www.gillespieresearch.com/cgi-bin/bgn

It’s among the best you’ll find in the business. But, like most worthwhile analysis, you have to pay for it.

[powayseller]

Yes, inflation is higher than reported in the CPI. The question is whether you get a higher rate of return on the TIPS than on Tbills/Tbonds. With interest rates edging up, it’s more attractive now than it was a couple years ago. I think it’s better to buy a TIPS which loses 1% annually to inflation, than to be in the money market which loses 60% because the underlying FNM bonds lost value, or to be in the stock market as it undergoes a 15% correction. That’s my general thinking. Am I missing anything?

[Author]

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