shorting the american dream

for the last few months i have been talking about shorting fannie mae. in several discussions, i have been accused of advocating “betting against the american dream”, which i guess is correct. fannie mae and freddie mac, known as government sponsored enterprises (GSE), are in the business of packaging mortgages and securitizing them. when investors are buying up the stock and bonds, money flows into the the mortgage market and provides average americans with low stable interest rates, enabling them to participate in the ultimate american dream: home ownership. many investors believe that GSEs are guaranteed by the US government, (and a more sophisticated view is that even if they are not, the US government can not AFFORD to let them fail). this gives rise to a moral hazard situation, which can lead to artificially low mortgage rates (because they do not accurately reflect the real risks in the underlying loan portfolios…the investment is perceived as less risky because it is believed in the case of a meltdown, the fed will step in with a bailout). loan officers and mortgage companies have the incentive to loan as much money as possible, to as many people as possible, to increase profits. lots of artificially cheap money in the mortgage market leads to lots of artificially inflated house prices, and the inflated house prices then show up as larger assets in the loan portfolio, which they can then lend against. it’s a credit bubble. supply is tight because there is so much demand when so many people can get so much money for so little interest. ok, well that’s the background.
the real problem right now is that fannie mae is drowning in fraudulent accounting. they have “overvalued its assets, underreported credit losses, and misused tax credits”, to the tune of an estimated $10.8 Billion. they can’t get a handle on restating their financials for years past, and it is widely believed that they will not be able to make an accurate accounting for 2005. this is the largest holder of home mortgages in the US that we are talking about here. Greenspan said on sept.2 that “excessive caution in reducing their [Fannie Mae’s and Freddie Mac’s] portfolios could be destabilizing to our financial system as a whole and in the end could seriously diminish the availability of home mortgage funds”.
well i waited on the sidelines a littlle too long. when the motley fool has picked up on the story, the opportunity to profit from the distortion is probably gone. but the implications for pain in the real estate market and the broader economy are without question still there.