On Thu, Jan 02, 2003 at 08:40:12PM -0500, Kevin Tarr wrote: > I've been waiting all day to reply to this thread, since reading on > line at work. For the original question: Erik, do you get any AM > stations that carry the financial network, or similar name?
I don't usually listen to the radio much -- I get most of my news from the web and I live 1.5 miles from work so I don't have much time to listen in the car most days anyway. > I listened when I could pick them up in central PA, above I-80, > on 1520 from Buffalo or Rochester. On Christmas Eve during on my > long drive home I picked the station up. A caller was asking about > funds which were based on home loans. He couldn't believe they were > selling well, or the claims they were making, promising returns of > above 6-8%. The caller said, if the loan rate is 5-6%, how can they > make 6-8%. And who hasn't refinanced their homes by now? (Yes there > are always new home buyers, but he was talking about a re-finance > company.) Do you know what exactly he was talking about? Did he mention the Fannie Mae or Freddie Mac stocks? Or was he referring to the mutual funds that invest in so called "GNMA's" and other mortgage-backed securities? If they were talking about GNMA mutual funds, then you need to remember that holding bond funds is quite different than holding actual bonds. If you hold a bond (and you plan to hold it to maturity, never selling it) with a 5.5% coupon, then you will earn 5.5% per year on your investment. But if you hold a bond mutual fund, it is more complicated because of fluctuating interest rates and the fact that the mutual fund is continuously buying (and sometimes selling) bonds. So the NAV (net asset value) of the bond fund depends on the value of the bonds it holds, which in turn depends on the coupon rate of the bonds *AND* on the present (and future) interest rates that are available on the open market. For example, if you just bought a $100 bond with a maturity of 30 years and a 5.5% per year coupon, it is naturally worth $100 at the instant you bought it. But if soon after you buy the 5.5% bond, interest rates go down to 4.5%, then your bond is now worth about $116. That is because on the bond market, the newly issued bonds are only paying 4.5%, so your bond at 5.5% is more attractive to potential buyers. If you sold your bond after one year when interest rates fell from 5.5% to 4.5%, then you made $16 on a $100 investment for a return of 16% on a 5.5% coupon bond (this is slightly simplified but it is approximately correct). Conversely, if interest rates rise from 5.5% to 6.5% after you buy your bond, then your 5.5% bond is only worth about $87 on the bond market. Since interest rates have been falling since sometime in 2000, bond funds have had returns much higher than the yields of the bonds they hold over the past 2 years (because the bond fund returns include both the interest the bonds earns and the appreciation in the market value of the bonds they hold). However, everything I read suggests that 30yr mortgage bonds *CANNOT* go any lower, eg., guru Bill Gross from PIMCO: "There will never be much less than a 5% 30-year GNMA, Freddie Mac, or FNMA mortgage issued in size no matter what Greenspan does - and that's a forecast you can take to the bank, with a high probability outcome. No investor in their right mind would be on the buy side of a 30-year mortgage with a 4% coupon and a potential extension from a 5-year, to a 12, to an 18-year average life life staring them in the face." http://makeashorterlink.com/?M146232F2 So, if rates can't go down, they will either stay the same or go up. That means that in the future you should expect to earn no more than the current yield on your GNMA fund, and possibly lower if interest rates rise. On the other hand, if the radio show you heard was talking about the equities, like Fannie Mae (NYSE:FNM), then the price of those equities are driven by expections of future earnings, which in turn are influenced by leverage, volume, and costs. So, if people expect that FNM will increase their earnings per share (EPS) in the future (not a bad expectation, since the population is growing), then each share of stock should appreciate at least as fast as the earnings per share increases. Also, Fannie Mae is highly leveraged, over the last 5 years its debt-to-equity ratio has increased from 27 to 42. If you have a D/E = 42, you could take a $100 investment, borrow $4200 at say 4.5%, loan the $4200 at 5.5% interest rate, then you make a profit of $42 per year on your investment of $100, for a return-on-equity (ROE) of 42%. Not bad, huh? But leverage this high is unusual, almost nobody but FNM and FRE are leveraged this high. Few banks are leveraged that high -- Citibank, for example, is leveraged at less than 4. The problem with high leverage is that if your income suddenly decreases for some reason, then your total debt can easily exceed your equity (total net worth) and so you can't meet the interest payments owed on the debt, and you can't liquidate your assets to pay off the debt. For example, if you put your total net worth down as a down payment on a house, and that down payment is 5% of the house purchase price, then your leverage is 20. If your house price appreciates at 6.5% per year and your loan is at 5.5%, then you are earning 20% on your investment of your house down payment (you are increasing your net worth at 20% per year, but the leverage goes down as your home equity increases). On the other hand, if they bulldoze your next door neighbor's lot and install a sewage treatment plant and your home suddenly goes down in value by 50%, you lost a whopping 1000% on your investment and now have equity of -45% of the home purchase price. In other words, if you sold your house, then you would be short by 45% of the original purchase price of paying off your mortgage, which means you owe 9 times your former net worth and have no assets to secure the debt. If you want to sell your house or if you lose your job and can't make the mortgage payments, you will have to default on the loan. So, if FNM's income suddenly decreases (which could happen if there are a lot of mortgage defaults combined with fewer new mortgages being bought) and their costs increase (if the market thinks FNM is in risk of going bankrupt then the interest rates at which FNM can borrow money would go up drastically and so increase FNM's costs), then there could be big trouble. The reason they can get away with this high leverage where banks can't, as far as I can tell, is two-fold. One, they invest some of their reserves in derivatives which they claim hedges away some of their interest rate risks. I have my doubts about this, since I'm not sure *anyone* has good quantitative knowledge of all the risks involved (it is the so called "black swan problem", see the excellent book _Fooled by Randomness: The Hidden Role of Chance in the Markets and in Life_ by Nassim Nicholas Taleb for more details). But the main reason they can get away with the high leverage is because, although their stock is traded publically and owned by individuals, they are a "government sponsored enterprise" (GSE) and there is an implicit guarantee that the US Treasury would step in to pay off the debts if GNM ever blew up financially. Implicit, not explicit, so it is sort of an assumption that everyone is making, but since the US government bailed out the savings and loans in the 80's, and since easy availability of mortgages (which FNM facilitates) are so important to the economy and to voters, it is probably a good bet. This means that FNM's costs are low because their costs are almost entirely interest payments on the money they borrow, and the interest rates they have to pay are lower since lenders perceive their risk of default as being lower because of the implicit government backing of the loan. > His other point was these companies were lowering and lowering their > requirements, giving loans to people who five years ago would have > been turned away. I know there are minimum requirements, but of course > this business has it's shady deals like any others. Yes, I had heard that also. The mortgage insurance company I am looking at is at some risk of future earnings decreasing if Fannie Mae reduces mortgage insurance requirements, which Fannie Mae was threatening to do. Evidently it has been worked out now, though. I have to look into it some more, since I'm not sure why/how it worked out (maybe Fannie Mae decided to keep mortgage insurance requirements the same when they saw how much defaults have increased recently, the default rate has gone up every quarter for the last 2 years) -- "Erik Reuter" <[EMAIL PROTECTED]> http://www.erikreuter.net/ _______________________________________________ http://www.mccmedia.com/mailman/listinfo/brin-l
