At the time, I got excited. I thought real action was coming. Unfortunately, my initial prejudice against fellow Americans held up. They are lazy, gullible, and apathetic. If I touched a nerve there, prove me wrong. I’m about to show you a significant flaw that has already made a small group of people serious money. If you want in, it’s time to man up.

Further Perversion of MBS Ridiculousness

So far, the U.S. government has piled up more than $2 trillion worth of debt to finance bailouts for banks, insurance companies and even the struggling auto industry. And unless you are the CEO of one of these companies or worth enough to make sweetheart deals like Warren Buffett, you haven’t received a dime of this money. That’s all right, because the government’s overreaction to this recession left an opening for gutsy investors.

As you know, mortgages have been the central problem in today’s economic meltdown. From there, greedy financial product creation boards went crazy. You’d have to be living under a rock not to hear the terms “collateralized debt obligations” and “credit default swaps.” These are the real doozies in today’s market slide.

However, the most important term in today’s financially-minded world is “mortgage-backed securities.” You see, it’s not the mortgages that caused the system to fail. It was the mortgage-backed securities, or MBS. These securities are not a new development in the financial world. In fact, they’ve been around longer than most of the “too-big-to-fail” banks Washington is bailing out.

During the last Depression, in 1938, President F.D. Roosevelt helped create the National Mortgage Association. Later, the word “federal” was added to the beginning. This organization, now called Fannie Mae, was created to bundle mortgages together and resell them as – you guessed it – mortgage-backed securities.

Wall Street’s further perversion of this already perverted “asset class” is a story for another day. But these “securities” are important today because the actions of the last 9 months of government intervention combined with plenty of MBS ridiculousness created an enormous opportunity for income investors.

You see, 2008 was a tough year for Fannie and her brother, Freddie Mac. Both companies’ shares lost about 98% of their value. The highly incompetent and worryingly scared Bush Administration took them over. In a very important piece of legislation, these two government-sponsored enterprises (GSE) were placed under the authority of the brand-new Federal Housing Finance Agency (FHFA).

In September, the FHFA took extraordinary action by placing Fannie and Freddie into a federal conservatorship. This conservatorship, backed by the U.S. Treasury, was designed to guarantee all GSE-backed securities. This September announcement means that the U.S. Treasury is obligated to pay anyone holding a Fannie- or Freddie-backed MBS. That’s a 100% guarantee by the U.S. Treasury. In a moment, I’ll tell you why this is important…

The Pseudo-Bank Loophole

The financial industry is full of penniless banks, uninsured insurance companies, and toxic assets. But it also includes about five pseudo banks that are in the perfect spot to take advantage of the collapsing market and the U.S. government’s desperate attempts to save it.

These companies are called mortgage real estate investment trusts, or REITs. If someone would’ve come up to me and asked me what I thought about a mortgage REIT a few weeks ago, I’d have laughed at them. But after I did some research, I found a bailout loophole that this small sector uses to make a few people very rich.

These mortgage REITs buy mortgage-backed securities from Fannie, Freddie, and occasionally Ginnie Mae (Government National Mortgage Association) at about a 5% yield. Until Bush’s ridiculous Fannie/Freddie bailout, the only government-backed securities came from Ginnie. Now, after the September conservatorship announcement, Fannie- and Freddie-backed securities are backstopped by the U.S. Treasury. That means whoever holds securities originally bundled by Fannie, Freddie, or Ginnie will get paid.

I can’t stress this enough… Until the U.S. government declares bankruptcy or the Chinese army overtakes Fort Knox, these securities are as safe as Treasury Notes. But here’s where it gets interesting…

Multiplying the Spread for Government-Guaranteed Income

The five (or so) pseudo banks that receive this “government-guaranteed” income from mortgage securities are still financial companies. And what do financial companies do? They leverage the hell out of any debt they can grab.

Here’s how it works:

Mortgage REIT A buys a bunch of government-backed MBS from Fannie. In turn, he receives a AAA+ credit rating because his portfolio is 100% backed by the U.S. government. He takes his credit rating to Lending Banks X, Y and Z. These banks give REIT A a bunch of 90-day, $100 million loans at 2% interest to buy more mortgage securities from Fannie. And we repeat, again and again.

When all is said and done, REIT A is leveraged 6-to-1. Its income comes from the 3% spread between its borrowing rate and the yield on the MBS. Multiply that by its leverage ratio, and REIT A grosses 18%.

Because of an obscure law that publicly traded realty companies cut decades ago, REITs aren’t taxed (so long as they pay shareholders all of their earnings through dividends). Therefore, with everything else equal, REIT A’s shareholders receive an 18% dividend yield.

With interest rates artificially held down by the Fed, and government-supported mortgage yields artificially held high to promote more MBS buying, we get a spread (and thus, income) that’s extremely large. And with these companies required to pay shareholders all of their earnings, we get an extraordinarily large dividend yield.

Finally, because of the mortgage mess, shares of these companies are undervalued. While most financial companies deserve their shares driven into the ground, these mortgage REITs don’t.

Investors with big cojones have already taken advantage of this. The spreads are even larger and safer now. If this is new to you, I suggest you check it out before investors jack shares back up – deflating the dividends’ effect.

Sincerely,
Jim Nelson

April 6, 2009

Fannie Mae and Freddy Mac for Safe Income was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

To switch metaphors, let’s say that we are witnessing the two stages of a tsunami. The current disappearance of wealth in the form of debts repudiated, bets welshed on, contracts cancelled, and Lehman Brothers-style sob stories played out is like the withdrawal of the sea. The poor curious little monkey-humans stand on the beach transfixed by the strangeness of the event as the water recedes and the sea floor is exposed and all kinds of exotic creatures are seen thrashing in the mud, while the skeletons of historic wrecks are exposed to view, and a great stench of organic decay wafts toward the strand. Then comes the second stage, the tidal wave itself — which in this case will be horrific monetary inflation — roaring back over the mud flats toward the land mass, crashing over the beach, and ripping apart all the hotels and houses and infrastructure there while it drowns the poor curious monkey-humans who were too enthralled by the weird spectacle to make for higher ground. The killer tidal wave washes away all the things they have labored to build for decades, all their poignant little effects and chattels, and the survivors are left keening amidst the wreckage as the sea once again returns to normal in its eternal cradle.

So, that’s what I think we will get: an interval of deflationary depression followed by a destructive wave of inflation that will wipe out both constructed debt and constructed savings, scraping the financial landscape clean. There’s no question that stage one is underway. But we can be sure the giant wave of money recklessly loaned into existence in just a few weeks time will wash back through the global economy leaving a swath of destruction.

And then what? The societies of the world will be faced with the task of rebuilding systems of fruitful activity, i.e., real economies based on productive behavior rather than the smoke-and-mirrors of Frankenstein-finance con games. In fact, excuse me while I switch metaphors again, because the Frankenstein story — the New Prometheus — is yet another apt narrative to inform us what we have done. We have “played” with financial fire and brought to life a monster now bent on killing us. One question that this metaphor-narrative raises is: when will the angry peasant mob storm the castle with their flaming brands and cries for blood from the makers of this monster? Rather soon, I think. Perhaps, in some countries (maybe the USA, if we’re lucky), this will take the more orderly form of systematic prosecutions, bringing to justice persons who perpetrated swindles involving the alphabet soup of investment “products” that have gone bad in so many accounts (and ruined so many individuals, institutions, and governments). I think it has already begun with the inquisitors summoning the shifty Dick Fuld of Lehman Brothers — but there are hundreds of other characters like him out there, who scored untold millions of dollars in activities that were simply grand swindles. I wouldn’t be surprised if, eventually, Treasury Secretary Hank Paulson found himself in the dock to answer how come, when he ran Goldman Sachs, there was a special unit in the company dedicated to short-selling the very mortgage-backed securities that another unit in the company was so busy pawning off to every pension fund on God’s green earth.

Apart from orderly prosecutions (which can certainly turn harsh and cruel), there is the possibility of sociopolitical upheaval — revolution, violence, civil war, war between nations, the whole menu of monkey-human mischief that afflicts mankind. We are not necessarily immune to it here in the USA, despite our cherished notion of exceptionalism, which would have us inoculated against all the common vicissitudes of history.

Anyway, prosecution through the courts, while perhaps satisfying the hunger for justice (or, more particularly, revenge), is not a productive economic activity. So, the question begs itself again: what will we do? Under the best circumstances we will reorganize our society and economy at a lower level of energy use (and probably a lower scale of governance, too). The catch is, it will have to be a whole lot lower. I think we’ll be very lucky fifty years from now to have a few hours a day of electricity to do things with.

The energy story and its handmaiden, the climate change situation, are both lurking out there beyond the immediate spectacle of the financial fiasco. Both these things imply pretty strongly that the economic relations currently unraveling will not be rebuilt — not the way they were before, or even close to it. The best outcome will be societies that can practice small-scale “process-intensive” organic agriculture and equally small-scale process-intensive modes of manufacture in the context of very local sociopolitical networks. An accompanying hope is that we can remain civilized in the process. Personally, while I recognize the appeal (to others, not me) of the “singularity” narrative, which has the human race making a sudden evolutionary leap into some kind of cyborg-nirvana, I regard it as an utter bullshit fantasy that has zero chance of occurring, given our stark predicament.

But returning to the short term, or “the present,” shall we say, there is the matter of how the U.S. gets through the election and then the first months of a new government, even while the larger fiasco continues. I feel sorry for anyone who is placed nominally “in charge” of things this coming year. The best the President can do is offer some reassurance to a public that is totally unprepared for the convulsion now upon us. He will certainly not have “money” to “spend” on any of the promised social support programs that have been endlessly debated. But he could clearly articulate the reality we’re facing, and ask not necessarily for “sacrifice,” as the common plea goes, but for something more and better: For bravery and resolute spirit, for intelligence and resilience, for kindness and generosity — among a people long unused to consorting with the better angels of their nature. The change that has been in the air all year — that Mr. Obama has talked so much about — is coming in a bigger dose than anyone expected. I hope we’re ready to get with the program.

Regards,
James Howard Kunstler

October 24, 2008

What Now? was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.