RE-FINANCING

The re-fi mania was a very rational decision for those who locked in long-term rates, but a far riskier decision for those who signed up for Adjustable R*te Mortg*ges (ARMs).

If you did not refinance your home at a three-year fixed rate, you missed a golden opportunity to skin the victims of Greenspan’s policy of lowering short-term rates, i.e., the lenders. But don’t despair. There will be another opportunity. All it will take is the destruction of the dollar.

When the Fed’s monetary inflation pushes up price inflation, as it will, and price inflation then produces inflation premiums for long-term loans (“Don’t pay me off with those depreciating dollars!”), both Fannie Mae and Freddie Mac will face bankruptcy on a scale larger than anything seen in Western economic history. There are trillions of dollars at risk between them. They hold the paper for half of America’s home mortg*ges. At that point, Greenspan & Co., sensing the threat of “cascading cross defaults,” will start buying T-bonds again, forcing down all long-term rates, including mortg*ge r*tes. The Japanese central bank has done this for 10 years. Why not the Fed?

But if the Fed does this in the face of a true sell-off of bonds, it will take an enormous increase in monetary inflation. This will put more upward pressure on mortg*ge r*tes.

I will get to this shortly, and what it means for home values. But first. . . .

SPAM BLOCKING

Why do I keep writing “mortg*ge r*tes”? Because of spam-blocking software that many, many Internet service providers have installed. This software blocks phrases that spammers commonly use. This includes you-know-what. The refinancing mania filled our Internet service provider (ISP) mailboxes with offers for lower mortg*ge r*tes. These offers began to annoy some ISP clients. So, they complained. The rest of us — the vast majority — grinned and bore it. So, to get the complainers off their backs, ISP managers direct their programmers to Do Something. Installing spam-blocking software is what they do.

The average ISP client doesn’t know that his mail is being blocked. So, he doesn’t complain to the ISP. The anti-spammers are vocal. They do complain. The squeaky wheels get greased.

The rest of us now enjoy an advantage: less spam.

This comes at a price: reduced liberty of communication.

There is one very large ISP company that blocks 70% of the subscribers to my email newsletter. I must not upset anyone in senior management of the firm, or else they may start blocking the other 30%. So, let me describe this firm.

It used to send out free CD-ROM’s with their program, offering 80 hours (then 120, then 500 then 1,000) of free Internet time.

Its clients, once signed up, cannot easily locate the address for “I’m canceling,” so letting their credit cards lapse is the only known escape.

The company, by merging with Ted Turner’s company, reduced Mr. Turner’s wealth by about 80% by forcing down its newly merged stock price (as I publicly predicted it would in February of 2000), thereby forcing Mr. Turner to renege on his promise to donate a billion dollars to the United Nations, which is why I — no longer a client, having let my credit card lapse — applaud this company.

It is my hope that this company will go bankrupt, thereby wiping out the rest of Mr. Turner’s fortune, now that “Gods and Generals” lost so much money that Mr. Turner will not finance the third movie in the series.

BROADBAND VS. MODEMS

I live in the sticks. So, I’m tied to a modem. If I lived in the city limits, I would get broadband: cable modem, DSL, or something. Everything online works faster with broadband.

It costs more, but the value of my time, and any businessman’s time, is far higher than the extra monthly fee for broadband.

There are also ever-cheaper ISP services. Poetworld costs $8/month for 200 hours. The problem is, they are cheap because their customer service is lousy. I have called. No such service. I have e-mailed. No reply. I have been a customer for a week, and already I am not happy. But my wife uses the service, and it works well. My son-in-law taught her how to set it up.

This means that this service is for experienced users. Newbies must go to higher-priced local services or else the previously mentioned company that blocks my letters.

I use two ISPs. I need a backup. That’s because my business is tied to the Web. I have to have access. If one ISP goes down, I need a backup. That’s why I signed up with Poetworld. It replaces That Other Company.

As experienced users move to broadband, as they have been doing by the tens of millions, local services will get squeezed. Inexperienced users will demand free support, while experienced users will move to DSL or cable modem. To compete, local ISP’s will have to offer cheap broadband service. They will find themselves competing against well-financed national companies.

For those who require hands-on technical support, the local ISP is best. For those who desire high-speed downloads, cable modem or local DSL is best. For those who are too timid to pay extra for the power and convenience of a high-speed connection, or go to the trouble to learn Netscape Navigator, Opera, or Microsoft Internet Explorer, That Other Company is best, with its daily mailbox full of spam, despite its spam-blocking software that keeps people from receiving my newsletter.

I suggest that you make a switch.

FANNIE MAE . . . BUT FOR HOW LONG?

The Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) are private investment organizations that enjoy the reputation of being backed by Congress in some way. Freddie Mac really does call itself Freddie Mac. I dare you to discover its real name on its Web site.

This reputation of being backed by Congress has led to their ability to attract investors to the tune of trillions of dollars. The fact that these are GSE’s — government-sponsored enterprises — does not mean legally that Congress must bail them out if they go under. It’s a political question. It’s also economic. How could Congress bail them out when the government is already running a deficit of $450 billion a year?

These GSE investments have gone into mortgages. Like bonds, these paper investments fall in value whenever long-term interest rates rise. Also, they get repaid early through re-financing at lower rates whenever interest rates fall. They are, in short, terrible investments. They are asymmetric, with both sides of the transaction favoring the debtors against the creditors.

One of the services I perform is to keep you informed of what is being written in the financial press. When I find someone who says something better than I do, I cite him or her and provide a Web link, if possible.

The New York Times (Aug. 8) ran an article on Fannie Mae by Alex Berenson. Its language was subdued. Its message was “Red Alert! Red Alert!”

Fannie Mae, the giant mortgage finance company, faces much bigger losses from interest rate swings than it has publicly disclosed, according to computer models used by the company to estimate the value of its assets and debts.

At the end of last year, the models showed that Fannie Mae’s portfolio would have lost $7.5 billion in value if interest rates rose immediately by 1.5 percentage points, internal company documents provided to The New York Times indicated. At that time, the market value of all the assets on Fannie Mae’s books, minus all the company’s debts, was about $15 billion. So it would have lost roughly half its market value from such a sharp increase in interest rates, according to the models.

With $923 billion in assets, Fannie Mae is the second-largest financial company in the United States, trailing only Citigroup. Fannie Mae, which is sponsored by the Federal government, helps keep mortg*ge r*tes down by buying mortgages from banks and selling them or its own bonds to investors around the world. But some investors and outside experts say the company has become dangerously large and highly leveraged, with too much debt and not enough equity.

The models were provided to The Times by a former Fannie Mae employee, in return for assurance that he not be identified.

The company’s chairman, Franklin D. Raines, responding to a question at a news conference last week, said Fannie Mae did not depend on the market value of its portfolio to judge the success of its business. Asked whether Fannie Mae constructed such estimates weekly, he did not reply.

In interviews yesterday, executives at Fannie Mae acknowledged that the company estimates the value of its portfolio weekly, though it discloses such information to investors only once a year. The models provided to The Times are several months old, the executives said, and present an incomplete and misleading view of Fannie Mae’s finances. They added that Fannie Mae hedges its risks properly and discloses them fully to investors.

“There is no reason for anybody to be worried about the company,” said Peter Niculescu, Fannie Mae’s executive vice president for the mortgage portfolio. “We are very happy, comfortable, and proud of our performance this year in what has turned out to be a very volatile interest rate environment.”

Mr. Niculescu declined to say whether Fannie Mae’s portfolio had gained or lost value this year.

The former employee, who now works for a company that does not directly compete with Fannie Mae, said he had decided to publicize the documents because he was worried that Fannie Mae was becoming a risk to taxpayers and the financial system.

Because it is so large, and because many investors think that the Federal government will repay its bonds if the company cannot, the government could become engaged in a very expensive bailout of Fannie Mae if it mismanaged its risk, the company’s critics warn. And if investors balked at buying Fannie Mae’s bonds because they were concerned about the company’s financial strength, mortg*ge r*tes could rise rapidly.

For years, critics of Fannie Mae have warned that it does not give them enough information to judge its risks. “I have no clue” about the company’s sensitivity to interest rate moves, said Stan Jonas, managing director at Fimat USA, a bond and derivatives broker. “But no one else does either.”

Fannie Mae has never publicly disclosed how much money it could lose if interest rates rose 1.5 percentage points in a very short period of time. The company said in its most recent annual report that if rates rose 1 percent on Dec. 31, it would actually have made $600 million. But that figure included gains that were not directly related to the value of its mortgages. In fact, the model predicted that Fannie Mae’s portfolio would have lost $2.6 billion if rates rose 1 percent. From June 13 through July 29, the yield on the 10-year Treasury note, the benchmark of long-term interest rates, rose 1.33 percentage points, from 3.11 percent to 4.44 percent. The yield has since fallen slightly but remains more than 1.2 percentage points above its June low.

Mr. Niculescu said Fannie Mae had moved in the last few months to protect itself more aggressively from interest rate changes. Compared with other financial institutions, he said, it is well hedged and has plenty of capital.

Fannie Mae has not disclosed how much the recent rise in rates affected the market value of its holdings, and analysts have wildly varying estimates. Kenneth Posner, a stock analyst at Morgan Stanley who is bullish on Fannie Mae, said it did not disclose enough information for outside analysts to determine monthly changes in the portfolio’s value.

This could create havoc for the U.S. Treasury bond market, as Gretchen Morgenson wrote in the New York Times (Aug. 17). Note: this is not some oddball newsletter. This is the sedate New York Times. Get ready to sweat.

Although many investors think that the Treasury market sets mortg*ge r*tes, mortgage-backed traders are the ones who hold sway. Their hegemony is a function of two things: the runaway growth in the mortgage market and the way mortgage portfolio managers must respond when rates rise or fall.

Until 2000, the United States Treasury market was the world’s largest and most liquid. Now the government bond market is overshadowed by the mortgage-backed securities market. Treasuries and corporate bonds each account for about 22 percent of the Lehman Brothers United States Aggregate Index, a measure of the whole fixed-income market; mortgage-backed securities make up almost 35 percent.

This would not be a problem if mortgage traders and managers of big loan portfolios, like Fannie Mae, did not typically hedge their holdings with Treasuries. Holders of mortgages hedge by selling short Treasury securities with maturities roughly equal to the average life of the mortgages in their portfolio.

Now, the hedgers’ needs can swamp the market they tap. This exacerbates moves in interest rates, producing a snowball effect that can push rates far lower or higher, and faster, than in previous years.

Mortgage-backed securities respond violently to moves in interest rates. When rates fall and homeowners refinance, some of the mortgages in large portfolios held by banks, hedge funds and mortgage originators are cashed in. That requires the managers of these portfolios to rebalance their hedges by buying Treasuries. Such buying helped push interest rates down to ridiculous levels earlier this year.

When rates rise, refinancings drop, and the average life of a mortgage grows. That forces traders to rebalance portfolios by selling Treasuries. Selling begets selling; interest rates spike.

Last week, the Federal Reserve rattled the bond market by promising to keep rates low for as long as possible. Traders feared that the accommodative stance could be inflationary. They sold Treasuries, and rates rose.

James A. Bianco of Bianco Research in Chicago pointed out that the last time interest rates moved up — in the mid-1990’s — the mortgage-backed securities market was much smaller and more manageable. “Back in 1996, the mortgage market was roughly half the size of the Treasury market,” he said. “Now it is 125 percent of the Treasury market.”

Mr. Bianco fears that the size of the market and the fact that so many players are heavily leveraged make a disaster almost inevitable. “If you look at the last 15 years of bond market derivative debacles, a lot of them involved mortgages,” he said. “These things have killed more people than any other trade.”

The people running big mortgage portfolios would tell you that hedging allows them to manage away their risks.

Mr. Bianco argues that the extreme volatility in the market suggests that the players have not properly managed their risks. “We wouldn’t see these wild undulations in interest rates if they had already been hedged,” he said.

It is unfortunate that the problems of mortgage traders can create such havoc. But these traders drove down rates, benefiting consumers, companies and bondholders. Now, it is higher borrowing costs — and their grimmer implications — for which everyone must prepare.

Not worried yet? Well, then, take a look at Philip Coggan’s article in the staid, stiff-upper-lip London Financial Times. This ran on Aug. 11.

The speed of the retreat seems to have been driven by the peculiar structure of the US mortgage market. Most US homeowners borrow at a fixed rate, but unlike their British counterparts, they have a virtually free option to refinance their mortgage as rates fall.

Many of those mortgages are acquired by Fannie Mae and Freddie Mac, two giant US agencies. They either hold on to those mortgages or package them and pass them on to outside investors in the form of mortgage-backed securities.

Whoever holds the mortgages faces a risk. As long-term yields fall, homeowners will be tempted to refinance their debts. So instead of holding long-dated debt, the investor (or the agency) will suddenly be holding cash.

This can have dramatic effects on the duration (a function of a bond’s yield and term to maturity) of the mortgage-backed bonds, and of the agency’s portfolios. As yields fall, the duration dramatically shortens; as yields rise, it lengthens just as quickly.

In the jargon of the markets, such bonds have high convexity.

Naturally, the investors try to hedge this risk. When yields are falling and duration is shortening, they hedge by buying longer-dated securities such as Treasury bonds. This has the effect of driving down yields even further, creating a virtuous circle.

When yields start to rise, however, the circle turns vicious. Repayments dwindle, tending to lengthen the maturity of investors’ portfolios. This causes investors to sell longer-dated Treasury bonds, pushing yields up even further.

This vicious circle has kicked in over the past few weeks. As the duration of the mortgage-backed securities has lengthened, there has been heavy selling in the 5—10 year portion of the Treasury bond market. The same hedge can be achieved in the swaps market, where investors have been eager to borrow at a fixed rate (the equivalent position to shorting a Treasury bond); swap spreads have widened sharply.

The disruption to the market has been so great because these agencies are huge. They have traditionally been regarded as quasi-governmental organizations, allowing them to borrow cheaply. And they have taken on a vast amount of leverage.

They also have fairly rigid hedging policies. According to Mr. Wozniak, the agencies have stated that they will not tolerate a duration mismatch of more than six months. Recently, they have been at the limits of this mismatch, so they have been forced sellers, rather as insurance companies were forced sellers of equities around the end of last year.

How bad could it get? There are some who believe that Freddie Mac and Fannie Mae are the potential Achilles heels of the US financial system. Indeed there have been reports that the European Central Bank has advised other government banks in Europe to reduce their exposure to their debt.

A further rise in Treasury bond yields could release an immense amount of selling in the market. Tim Bond, of Barclays Capital, estimates that another 25 basis points rise in yields could prompt $180bn of sales in the 10-year swap market. In the past, such rapid market movement has caused distress in the bond market. One has the feeling that someone, somewhere has just lost his shirt.

HOUSING PRICES

If any of this happens — and eventually, it will happen — anyone with an ARM will be forced to sell his home, as his monthly payments rise. I call this “an ARM and a leg.” This will flood the market with unsaleable homes. As rates climb, the number of would-be buyers who qualify for loans falls. Also, the monthly payment rises, so people cannot afford to buy homes that they could have purchased when rates were low.

This is the bubble effect. It balloons when rates are falling. It pops when rates rise and are expected to rise even more.

To stop the rise in mortg*ge r*tes, one of two things must take place: (1) a depression, where all interest rates fall; (2) mass inflation, where the Fed buys long-term Treasury bonds. But the second policy is temporary. Eventually, no one will loan money because it will be re-paid in depreciated money. At that point, the Fed will be the lender of last resort in the housing market.

I think the latter is more likely.