How the "Smart Money" Loaded Up on Freddie Mac Shares Early This Year and Lost 70%. Now Experts Say, "No Problem!" I Say, "We Are at the Edge of a Cliff." Why? Look at These Charts.
July 12, 2008
We are in the third phase of what Warren Buffett calls the three I's: innovation, imitation, and idiocy.
As we shall see, the idiots went rushing in to buy Freddie Mac in the first quarter of this year. Their idiocy is now visible to the entire investment world.
Here is Freddie Mac's performance over the last year.
The experts did not see this coming. They bought all the way down.
If you have been paying attention to my advice on this website, you did see it coming. The US housing market was a bubble, and it was clear to me in 2005 that this bubble would soon pop. It did: in 2006. I knew there would be national price declines in housing, which had not happened since the Great Depression. I said so repeatedly. In November 2005, I wrote the following in an article titled, "Surreal Estate on the San Andreas Fault."
The American economy as never before rests on the housing boom. Yet this boom cannot be sustained much longer in the bubble regions. A recession looms. Even without a recession, the boom will falter because of ARMs: adjustable rate mortgages. These time bombs are about to blow, contract by contract.
Why was the smart money so blind? Because the smart money does not understand Austrian School economics. They have not read, nor would they believe, my chapter on the business cycle in my free mini-book, Mises on Money. They do not understand that when the central bank inflates, and then ceases inflating, there is going to be a recession. The smart money did not understand that the bubble was overwhelmingly a real estate bubble. They thought, "this time it's different." It wasn't.
Legg Mason and Capital Research Group, two large hedge funds, loaded up on shares of Freddie Mac in the first quarter. The shares are down 70% since March 31. The story is here. Unless the Federal government intervenes, Freddie Mac is likely to go bust.
Combined, the two funds own 18% of Freddie Mac. They have been sandbagged. They are not alone. Bloomberg reports: "About 48 percent of McLean, Virginia-based Freddie Mac's outstanding shares are held by 535 mutual funds, according to Morningstar. Washington-based Fannie Mae is held by 578 mutual funds, which account for 45 percent of the shares."
The managers would not heed the obvious warning signals in 2007. Their investors have therefore been hammered. Legg Mason shares had lost 23 percent as of yesterday morning.
The smart money investors who turned their funds over to the hedge funds that were committed to what is called value investing now find that the managers invested in a couple of turkeys. It's not as though these turkeys were not known to be turkeys in the first quarter of 2008. The housing market in the United States is suffering its worst decline since the Great Depression. Fannie Mae had been hit by an accounting scandal in 2004, which the market shrugged off. "We're all getting rich. Who cares?" Then it was hit by falling share prices throughout 2007. Freddie Mac was convicted of securitires fraud in 2007. Smart money said: "No problem!"
Everything about both organizations was wrong, and this should have been clear to anybody by January of 2008; yet these fund managers did not see this disaster coming. They thought it was all temporary. They thought this was value to buy. They thought "buy on dips." Well, they turned out to be the dips.
If the smart money could make decisions this stupid in the first quarter of 2008, then it believes its own headlines. It believes that the mortgage crisis is just a minor glitch. It believes that we are not in a recession that is going to last for years.
Ever since 2003, the smart money has believed that real estate was the engine of economic growth. But when the engine went off the tracks in 2006, the smart money believed that the rest of the train wouldn't follow the engine. It did. The smart money was wrong.
It is still wrong.
Do not believe the stories in the mainstream financial press that "the worst is behind us." These people don't know what they're doing, don't know what we're facing, and have no answers for the magnitude of the problem.
The man who should have the answers, Ben Bernanke, is extremely cautious, and says nothing about anything resembling a solution to the problem that Alan Greenspan created. He contents himself with delivering long speeches that survey the disaster and the promises that the Federal Reserve is reviewing the situation.
This economy is going to get a lot worse before it gets worse.
If you are short the stock market, stay short.
The site member who announced on a forum that he had shorted Freddie Mac and Fannie Mae on July 8, in response to my article predicting their bankruptcy or near bankruptcy, has done well. He sold Freddie short at $14. It opened on Friday at $4. At that point, Bernanke said Fannie and Freddie can borrow from the discount window. The stock rose to $8.
This subsidy of last resort was available only to banks as recently as last November.
The FED is desperate. It is willing to bail out the ultimate carry trade companies, which will borrow short (30 days) and are lent long (5 to 30 years). It's "too big to fail." It's moral hazard. A MarketWatch story had is right: the FED can loan to just about anyone.
The two outfits are so close to bankruptcy that Senator Dodd held a press conference to say that both are "fundamentally sound," and there is no need to panic. I can think of no better reason than to panic. When the politicians think a press conference is needed, they are at wit's end. Who do they think will believe Chris Dodd, the guy who received sweethart loans from nearly bankrupt Countrywide Financial?
The FED will find that everything large will come to its window. The FED can sell Treasury debt to offset the credits to Fannie and Freddie, but only until it runs out of Treasury debt. That will be next year, maybe within 12 months. Then the loans must be monetized without offsetting sales. Inflation will begin. It's what hard money editors have always said: the FED will eventually inflate.
This disaster is just getting started.
On the PBS NewsHour last night, there was an interview of three experts. One of them, Charles Duhigg of the New York Times, said that if the government takes over, "There is actually no necessary cost to the government or the taxpayers. . . . It would not obligate the government to pay anything." This is what passes for economic analysis at the New York Times. The bailout of two private companies that served as borrowers and brokers for mortgages of 42% of all mortgages in the U.S. go belly-up, but this will cost the taxpayers nothing.
Karen Shaw Petrou said, "Well, there isn't a real crisis. There certainly isn't anything new about Fannie Mae or Freddie Mac that we didn't know before." That is true, Karen. The collapse of the stock price for over a year has indicated that the companies are in desperate trouble. "The companies were and are undercapitalized. They were and are involved solely in mortgage finance, which isn't necessarily the most comfortable place to be. But there's nothing new and nothing dramatic that would create the crisis of the moment." In short, the collapse is old news, so let's not worry too much.
"These are sound firms." Karen, look at the stock prices! She said they have access to the capital markets. They do? If they have access to the capital markets, why did the FED have to give them access to the discount window? Because without this subsidy, no one else invest any money in them.
These people are spokesmen for the smart money. The smart money is going to lose a whole lot more money to match all they have already lost for their clients.
My advice: "Don't listen to them."