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 Red
October
“The bottom of a market hits bottom only when you quit asking…”
Daniel Cabretta
One can say that Fannie Mae & Freddie Mac have been a time-tested
Government Sponsored Enterprise (GSE)…too large to fail. However, on
September 8, 2008 the treasury department finalized one of the biggest
government bailouts in history, putting Fannie Mae & Freddie Mac under
conservatorship with the United States government. This takeover of the GSE
giants was no surprise to insiders.
The movie “The Hunt For Red October” is a perfectly-fitting analogy…a
sweaty, action-packed submarine thriller involving a technologically
advanced submarine engine that runs silent due to a revolutionary propulsion
system. The Soviet sub – equipped with a nuclear missile – is headed for the U.S. ... (Sounds a bit ironic based on our government’s course of action,
doesn’t it?). Recently, I all but guaranteed the bailout of both Freddie
Mac & Fannie Mae based solely on the explicit backing of these privately
held GSE’s by the United States government. How could they fail, and how
was I able to predict it?
Perception is everything
I have always said that perception is everything… The perception of a
Russian attack in “The Hunt for Red October” is very real… even though the
sub’s captain plans only to defect to the United States. Our perception
of Fannie Mae & Freddie Mac is that they are solid and invincible entities;
that perception is reinforced by their huge line of credit with the
U.S. Treasury, along with other tasty benefits, such as an exemption from
state and local taxes.
There is also the perception that “no risk” items such as government
bonds are safe issues; GSE bonds however, are not. They clearly state that
their “securities are not backed by the United States Government”. The
public perception is what caused a rally on The Street, the same day
as the bailout of Fannie May and Freddie Mac… the simple thought that if the
government steps in, our housing and financial crisis is over. The sad truth
is: solvency is still a very real problem. Without capital, Fannie &
Freddie are like a leaky sub… on a slow decent to the bottom of the ocean.
Government band aids (capital) thrown their way will only last so long. As
the contraction of money squeezes ever tighter, the result can only be total
failure.
Collision Course
Like sonar on a submarine detecting sinking depth charges, the depths of our
financial problems at this very moment ping deeper than ever. Through the
month of October, all mortgage-servicing companies, both large and small,
are adjusting for escrow shortages. Most new construction homes were never
adequately set up for “full escrow” amounts. Let me explain. Some
attorneys feel they are doing their clients a favor by bringing the
collection of property tax and homeowners insurance down to an unrealistic
number prior to closing on a home… just to make the “package” appear more
attractive. Case in point: I am aware of a “Gold Coast Chicago” attorney
who was pushing for an unrealistic $100.00 monthly tax escrow as part of
closing costs on a very high-priced condo –- a mere pittance compared to
what was actuality needed –- when next year’s escrow was a dead certainty to
be at least
$900.00
per month.
Lenders, by law, (once fully assessed) can hold enough in escrow to pay your
homeowners insurance and both property tax installments, plus two months
reserves, based on your tax due dates. On average (and to make things look
better for home buyers at purchase), escrow balances for new construction homes are
short thousands of dollars at this time in “OCTOBER”. When it comes
time to “pay the piper”, it is time for a true reality check. Typically you
have two choices: pony up the shortage or have the lender raise your
payment. Most borrowers don’t have the extra cash, so once again, up goes
the payment. Your investment may be on a collision course with foreclosure
because you never expected the torpedo created at closing in the
first place.
The
Option ARM / Alt-A Depth Charge
Option ARM (Adjustable Rate Mortgage) loans also start to adjust in October
and it’s neither a trick nor a treat at this point in time. By year-end,
escrow adjustments and interest rate increases on option ARM’s and Alt-A
loans (aka “liar loans” -- that never should have qualified to begin with)
will start to unleash their wicked reality upon us. Most people who were
sold these mortgages still have no clue as to how unkindly their rate will
readjust –- just another depth charge waiting to explode.
Fourth quarter bank ratings will plummet across the board. Over 300 banks
are now “weak” and turning into “very weak” institutions. At this point
they are either being merged into larger banks or will simply fail
altogether. The Federal Reserve will find it an exasperating task indeed to
keep consumer confidence high enough to get through the year. The risk of
systemic perception of pending doom will be global. The denial and
cover up of problems will finally be realized by year’s end… and that my
friend is the good news for 2008.
Run
Silent, Run Deep
The definition of recession is “a decline in business activity, often
defined as two consecutive quarters with a real fall in gross domestic
production (GDP)”, the broadest measure of economic activity. Consumption
is by far the largest component of GDP, totaling roughly two-thirds of GDP.
Gross Domestic Product on August 28th was pegged at 3.3%,
annualized up from an initial market expectation of 1.9%. Why so high?
Simply put, foreign demand for U.S. exports skewed the numbers. Take out
the exports and GDP grew by only
0.2%,
a far cry from our perceived notion that all is well on the home
front.
Often accused of being an extreme pessimist, I am simply a realist, and I
fear that our problems run deeper than they appear to run. But my point is
not to depress you but rather to awaken you to the reality of what is ahead.
Our denial has gone on for too long, even in our own back yard. Take a
look at our malls -- inside and out. Did you know for instance, that Charlestown Mall in St.
Charles, Illinois has an 80-90% vacancy rate within the mall
itself? Even the water fountain in the center court is no longer in
operation! They are not alone but I think you get the picture… not a good
one, but keep in mind this day and understand that, just like our personal
issues are eventually put to bed, time will pass and all will be healed and
forgotten. However, let’s not be so quick at heart to think that "peaches
and cream" is just a quick fix away. Smart –- and honest -- captains rig
for silent running and find a way to escape.
Franklin D. Roosevelt (1882-1945) assumed the presidency at the depth of the
Great Depression. A great man and a great President, he left us with two
outstanding quotes with which to guide our lives:
“Confidence… thrives on honesty, on honor, on the sacredness
of obligations, on faithful protection and on unselfish performance.
Without them, it cannot live.”
“The only thing we have to fear is fear itself”
Until next month, this is Danny On The Money.
Regards,
Daniel Cabretta
dannyonthemoney@sbcglobal.net
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