fnm and fre ought to be the biggest beneficiaries of the collapse of the mortgage-finance marketplace because they are the only game in town. they lend money; they never change their credit standards. they never did the no-down-payment, no-income-verification, teaser-rate kinds of loans that everybody else was doing. they were standing on the sidelines, crawling slowly, investing in fixed-rate, conforming loans. yes, they're still reporting losses, but they are taking accounting losses, not "real" losses.
the situation has been exacerbated by changes in accounting rules. since the last banking crisis almost 20 years ago, two things have changed dramatically - banks don't lend money anymore so much as arrange loans and then sell them through securities transactions and derivatives to other investors. thus, they tend to have less on their balance sheets. and, they have to mark their portfolios to market based on psychological perceptions of the loans' value. if banks had to do this in prior cycles, there isn't one of them that would have survived. and yet they all survived, because they don't lose the money everybody thinks they lose. some of these losses will turn into real losses, but the provisions the banks have taken against their earnings, which are a function of widening credit spreads and interest-rate changes, cause them to mark down their portfolios. here's an example: if you were a corporation that invested $100 in a us treasury bond that paid 5% interest, you'd get $5 a year. if interest rates go to 6% you have to mark down the value of the bond, even though you're still going to earn the same $5 a year.
capital adequacy is the real issue, because the accounting is the basis for capital requirements. it was easy for fre and fnm to raise capital. It was a huge positive surprise that these companies could issue as much preferred stock in the fourth quarter as they did, count it toward their regulatory capital requirements and not have to dilute common shareholders. And they are doing it in an environment where profit spreads have widened remarkably.the business they are writing today has returns on equity of between 25% and 40%, and they issued equity at between 8% and 9% to fund it. delinquency rates for fnm and fre have ticked up, but marginally, as opposed to subprime, where delinquencies have gone through the roof. but credit spreads have widened, so they have to reflect that in their books. they have taken massive write-downs beyond the money they expect to lose.
fnm and fre are perhaps selling for 25% or 35% of what they are worth, and the upside is three- or four-fold once the mortgage crisis unfolds. my opinion is that these stocks in the $20s don't make any sense, even in a bear case where they have to raise lots of capital. even if fre has to issue $5 billion in equity at $20 a share, massively diluting the existing shareholder base, you still come up with earnings power of almost $4 a share. in a best-case situation, assuming nobody else gets back into this market and they are the only game in town, you can get $9-$10 of earnings power for a stock that is in the $20s. one hardly ever sees that kind of risk/reward trade-off. hence, i am trying to buy as much as possible right here.
unfortunately, the credit markets have shut down. the problem isn't that there might be massive losses in these portfolios - i don't think there will be. estimates of the losses related to subprime mortgages range from $100 billion to $400 billion. even $400 billion or $500 billion isn't that big, within the scope of the enormous global economy. yet the credit markets are acting as if it's the end.
so, will credit concerns, even if they're misplaced, curb consumer spending? right now growth in consumer spending has probably slowed to long-term rates. in boom times the consumer might spend 5% more a year, and in busts spending might grow 1% a year. you don't see swings here like you do in other parts of the economy, because most consumer spending is for fundamental needs. spending on luxury and big-ticket items swings, but we didn't have a lot of excesses there. two million people are in homes they shouldn't be in, and it is unfortunate.
as for c, the siv picture turned out to be a non-issue, just as it was 3 months ago and 6 months ago. the issue is, should citi the stock go down 7 or 8x in market value for whatever the accounting loss is? meanwhile, the company has a very powerful consumer-credit-card franchise, most of which is outside the us. that is where they make all their money, because there isn't credit-scoring data. if you want to issue a credit card in the us, you go to the credit agency and get a fico score. there isn't that in emerging markets, or in lesser-developed countries. c is gathering more and more data, and if you have the data and nobody else has it, you can make loans. citi makes a lot of money in non-us consumer credit.
c's growth comes from being everywhere - it is a massive global franchise that will grow in line with global financial growth. this is a modest-growth, high-return business that should earn $5-plus per share in a normal environment. the consensus for next year is around $4, and the stock is about 24! it is not selling for a rich price, and that $4 is pretty stressed; it's a recession case. it could be lower if they have massive provisions or more write-downs - nobody knows, and that's why people are nervous. when people get nervous, they run for the hills.
downside risk, i believe, is book value at about 23 or 24 a share. looking out 2 to 3+ years, and i own 1/10 leap calls, i think there is a really spectacular risk/reward trade. the odds that c sells for less than 30 in three years are very low, and the odds of it selling for substantially above that are very high in my opinion.
as for other banks, bac, which i also own, is the same story. they are going through a downturn, so they're going to have losses and provisions. i'm looking for $4 for '08. right now, people aren't buying banks because the next quarter or two will probably be bad. whenever investors become hypersensitive to the next piece of information, value opportunities arise.
it certainly takes guts (stupidity? - i hope not!) to invest in the above right now. but my opinion is that one day, some people are going to get out of bed and decide the world just isn't ending just yet. right now no one is extending credit, and without credit, nothing gets done and that's obviously bad. however, the people who can make a difference and put a stop to all of this will eventually realize, to quote fdr, that we're just fearing fear. they'll start to really lend again and the system will repair itself.
disclosure: i own c and bac; and am planning on buying fnm and fre asap - remember: these are my opinions only - due your own DD!