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Thursday, May 29, 2008

Using Fannie Mae and Freddie Mac As Disaster Insurance

U.K. Home Values Drop Most on Record, Nationwide Says (Update3): “U.K. house prices fell in May by the most since at least 1991 as the shortage of credit starved the property market of buyers, Nationwide Building Society said.

The price of an average home dropped 2.5 percent from April to 173,583 pounds ($344,000), Britain's fourth-biggest mortgage lender said today in a statement. That's the largest decline since the index started in January 1991. From a year earlier, prices fell 4.4 percent.

Bank of England Governor Mervyn King predicted this month that property values are “likely to fall further” and said there is a risk that the U.K. economy may contract. Mortgage approvals dropped in April by 39 percent from a year earlier, the British Bankers' Association said this week.”

Pound Falls After U.K. House Prices Decline Most in 17 Years: “The pound fell to a one-week low against the dollar after an industry report showed U.K. house prices dropped by the most in at least 17 years, adding to the case for a cut in interest rates this year.”

The real estate bubble has burst the world over.

The U.S. obviously led the way with the collapse of the subprime market. Recent data from Existing and New Home Sales to the Case-Shiller price index show no signs of bottoming. The UK and Spain lagged by several months and are now in the process of really catching up. Real estate bubbles in other countries haven’t burst yet. Consequently they haven’t made the news yet, but they will.

The Commercial Real Estate market in the U.S. has now undeniably started to deteriorate. Expect the same from the UK and Spain.

Make no mistake; the worst is yet to come. Market clearing prices on real estate have yet to be reached. We know this because the months of supply of Existing Home Sales continue to accelerate upwards, jumping to 11.2 months in April. The only way the market can clear out this supply of housing is for prices to drop and to drop significantly.

Significant price drops, which CAN’T be avoided, will utterly demolish Fannie Mae (FNM.N) and Freddie Mac (FRE.N). A simple, cheap and low risk way to play out this scenario is with long dated Puts.

The January 2009 Puts on both FNM and FRE have significant open interest (OI). (See table)

First, this means that there is enough liquidity in these strikes for you to get in and out with the least amount of slippage.

Second, this also means others have had the bright idea to either hedge their FNM, FRE positions or their portfolios in general, or to aggressively bet on the annihilation of FNM and FRE. For example, the OI in the really low strikes, say $15 and lower, are really BANKRUPCY bets. OI in the lower strikes spiked in Bear Stearns and we all know what happened there.

Lets talk about the Greeks a bit on these January 2009 Puts.

The Puts are far enough out that Theta is at less than a penny a day. So you have time before time decay becomes a hurdle.

Implied Volatility is high. Vega is high to be sure, but both FNM and FRE have calmed down as they have been range bound for two months. So this is probably as good as it gets.

There are a number of option strategies you can employ to tackle FNM and FRE, the simplest of which to simply buy some Puts outright at a strike you desire.

FNM has been range bound between $25 and $30. Therefore strikes around here are ‘safest’. They are also more expensive.

FRE has been range bound as well in roughly the same area, so similar strikes could apply.

Some of the strategies available would help offset the cost of these puts, but would also limit some of the upside.

FNM and FRE will never be allowed to completely implode. If Bear Stearns was bailed out, then you can safely assume they will as well. If you assume that a bailout or rescue would occur at some token price you can imply that there will be a floor on the value of the common somewhere around about $5.00. So buying Puts with $30 and $25 strikes and selling the same quantity of $5 Puts to offset would ‘sell off’ the least amount of your upside and therefore efficiently reduce the cost of your position.

Now suppose housing prices immediately stop falling. (Seriously, a ridiculous scenario, but lets play it out.) FNM and FRE are still so impaired and their portfolios have deteriorated to the point where it is safe to assume their earnings will be severely stressed for three to five years. Their stocks are therefore likely to languish and give you the opportunity to exit the Puts at reasonable prices. Even in this scenario, both companies are likely to be forced to raise serious additional capital. The dilutive effects on the common shares should be large enough that the Puts are likely to gain in value even in this ‘best case’ scenario.

Now suppose home prices continue to collapse and that foreclosures continue to rise. This is the likely scenario. Now suppose that FNM and FRE will not be bailed out. Instead the politicians grow a pair and let the market sort the mess out. FNM and FRE will have to furiously raise capital of all kinds. Common. Preferred. Debt. All of it. Just to stay alive. The share price would therefore do a swan dive and the position would pay off.

It would be hard to imagine FNM and FRE breaking OUT and UP from these trading ranges. There simply isn’t any power in the universe that can save these guys or make them EARN money. They are stuck with massive portfolios that just need to be worked off.

For an interactive home price graph click here.

Research on Fannie Mae and Freddie Mac:

Calculated Risk:
Fannie Mae Tightens Guidelines Again
WSJ Repots: Fannie Mae Eliminate “declining market” Rules
Fannie Mae’s 120% Refinances
Fannie Mae on 2/28 Delinquencies
Fannie Mae’s Credit Loss Ratio: Fuzzy Math or Fuzzy Reporter?
On Freddie Mac Accounting Change
Freddie Mac Conference Call
Freddie Mac on Walking Away
Freddie Mac: Project MI Lifeline?
More on Freddie Mac Housing Forecast
Mish’s:
Fannie Mae Cumulative Defaults (and other disasters)
New Rules At Fannie Mae Combat Appraisal Fraud
Delinquency Footnote #12
Misinformation From Fannie and Freddie On Walking Away

Excellent Sources of Real Estate Data:
Calculated Risk
Countrywide Foreclosure Blog
Paper Economy
UK Bubble

FNM and FRE Make Me Angry:
Fannie Mae and UBS Miss, Bankruptcy Filings Up Big Time
Sarcastic Rant on Fannie and Freddie.
Fannie Mae, Freddie Mac: The Dumbest Idea Ever
Fannie Mae: Another Shoe Drops

4 comments:

Alice cook said...

check out the Irish property market. It is possibly the biggest baddest bubble of them all. Since January 2007, it is down about 10 percent.

Ben Bittrolff said...

Alice,

I was actually looking at that earlier... and trying to figure out a low risk way of playing the "Ireland Housing Bubble Bust" card.

From Fannie Mae, Freddie Mac, MBIA, Ambac, Countrywide, WaMu, Corus and others, I know where the toxic garbage is. Ireland and Europe I just don't have the same level of confidence. Maybe you can help with a post on the worst offenders... the guys that are going to get stuck eating the losses... (So we can all slam in short)

UK Bubble: Housing Bubble is Over

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