Gold, Oil, Fannie & Freddie

Oil and Gold Prices might look frothy. But figure in the risks to GSE-backed US mortgage bonds...

RIGHT NOW crude oil is going up faster than Gold, writes Dan Denning for The Daily Reckoning. Both are leaving the Dollar in the dust. Anyone buying real estate or mortgage debt in the vain hope they've hit rock-bottom can only gasp at what oil and the Gold Market have achieved.

   Gold Prices are up more than 50% from six months ago. Crude oil just set its ninth new high in the last ten trading sessions. The front-month futures contract traded at $108.21 per barrel in New York on Monday.

   Why is oil sprinting past gold? Both are hedges against inflation and US Dollar weakness. But in simple terms, it's easier for large players to be long oil than long gold. Crude oil futures are the most actively traded contracts in the commodities market. If you want a quick trade, or so the thinking goes, that's where you head.

   But any port in a storm, goes the old saying. Both oil and Gold Bullion make a nice, safe port during the current turmoil. Keep an eye on the trade, though. Not least in the short term. It's getting crowded.

Gold, Oil, Fannie & Freddie: Three-Phase Bull Markets

   There are three phases to any bull market. The first stage is the undervalued stage, when an asset class bottoms and nobody notices. That is the very best time to buy, but also the most difficult. It has long since passed.

   The next stage sees the price go up to where – in the case of equities – future earnings are fully valued in the current price. The stock is neither cheap nor dear. For oil and gold, this was probably 2004-2006.

   Then comes the insanity, where a stock keeps going up because it keeps going it. People buy it simply because it's rising. We are getting close to that stage with oil and gold, or so it seems. But a big factor in how they go from here will be how much lower the Dollar can go. Between now and next Tuesday, it may go even lower.

   The Fed meets Tues 11th March to decide on US interest rates. Judging by the futures markets, investors now fully expect the Fed to cut rates by 50 or 75 basis points. You're probably seeing the oil market price that kind of cut in already.

   We'd expect the oil price to come back a bit when, in fact, the Fed does cut rates. However these blow-off phases in bull markets can overshoot massively. That would leave oil...well...we'd put a number out there like $150 per barrel. But you'd just laugh.

   There is not much to laugh about if you're Ben Bernanke though. Nor if you're trying to make ends meet in the United States right now, or your real estate and mortgage investments are sunk in the dust left behind by oil and Gold Prices.

   It's not clear another rate cute will slow down the deterioration in the banking sector. The value of collateral keeps falling. Banks want their money back. Leveraged speculators have to sell to raise cash. And there is one extremely worrisome development that could rock the global financial markets to their foundations.

Gold, Oil, Fannie & Freddie: $4.2 Trillion in Mortgages

   Yes, it's been pretty bad up to now. But the government sponsored enterprises (GSEs) in the US – known as Fannie Mae and Freddie Mac – together guarantee over $4.2 trillion in mortgages. And incredibly (meaning "not credibly"), the GSEs have not yet sustained the same level of losses in their mortgage portfolios as the banks have.

   Can this last? Fannie lost $3.6 billion in the fourth quarter and Freddie lost $2.5bn. Both had to raise more capital. But compared to the banks, these losses are remarkably small.

   Here's the thing, however: the first wave of bad subprime debt came from mortgages originated in 2004. The delinquencies and defaults on those loans have been enough to cost the financial sector over $150 billion in losses. It's brought the credit market to its knees.

   The horrible news for investors is that loans originated in 2005 and 2006 already have much higher delinquency rates. They will have higher default rates, too. The last to join the US real estate boom will now be some of the first out. More than $600 billion in lower-credit quality loans were originated in 2005 and 2006. Already, about 5% of loans made in 2006 are more than 90-days delinquent on payments.

   It's not a shocker when you think about it. At the height of the boom, anyone could get a mortgage. But this means that the loans made in 2005 and 2006 – right at the peak of America's historic housing boom – could be the worst performing of the whole subprime lot.

   The shocking performance of these 2005 and 2006 loans hasn't been factored into banking stock prices yet. We would also suggest that no one yet knows how the mortgage portfolio of the GSEs – dear old Freddie and Fannie – is going to hold up this year. The idea that asset quality at the GSEs may become an issue this year is simply too scary for most investors to contemplate.

   Freddie Mac and Fannie Mae sell bonds to investors, whose cash goes to finance the new purchase of mortgages already issued and then "securitized" on the secondary market by private lenders. The GSE bond market was larger, for a period, than the US Treasury market. Central banks, pension funds, banks...everyone owns agency-backed bonds (as GSE bonds are called).

   If those bonds continue to fall in value, this whole mess reaches a new, truly scary phase. Where is it all headed? Eventually the Fed is going to have quit selling money cheap and start buying mortgages. We reckon the Fed will have to directly buy GSE debt in the near future. The liquidity issues in the financial sector will only finally be solved when all the suspect, infected, and putrid mortgage debt is either written off or finds a permanent home. The Fed is likely to be that home, fulfilling its mission of "buyer of last resort" along with "lender of last resort".

   Naturally, loading up America's national balance sheet with all the accumulated mal-investments from the housing bubble is not going to be a good thing for the US Dollar. So while the oil price looks a little frothy on its own right now – and while Gold at $1,000 is making pundits and investors gasp – when you account for the potential damage to the Dollar from the "nationalization" of the mortgage market, well...you ain't seen nothing yet.