Systemic Risk, SPX Correlation, and Fannie Mae

2006-08-23

Today's Thought of the Day comes from John Succo at Minyanville.

The actual correlation between SPX stocks over the last 30 days has been 0.19. Folks, the lowest this thing can go is zero and the highest is 100. In 1998 it was 98.

This means that when one stock goes down, like when Accredited Home Lenders (LEND) or Capital One (COF) or Lowe's (LOW) blows up, the money goes into other stocks that compensate. Correlation between stocks is low when people do not associate problems in one company to the next.

When investors connect the dots and begin to see risk increasing correlation rises.

Low correlation is closely tied to low volatility (it actually causes it in the indexes), but it tells us a little more. It tells us that even though volatility picks up in one stock because of problems, it is quickly sold in another. Low correlation implies the market believes there is low systematic risk.

As I said, 0.19 implies little concern for risk by investors, specifically systemic risk.

[Speaking about systemic risk in the banking sector Professor Succo went on to say]

Banks seem immune to any trouble. But if you own them please understand that your risk is rising substantially.

The flat yield curve makes it difficult to make money in general. But they seem to be doing alright on the surface. Let's look under the surface.

For the money centers, it is now clear they are making money mostly through capital market activity, which is risky.

But the real scary ones are the west coast banks. Barron's highlighted Washington Mutual (WM). In 1Q 2005 WM made about $23 million from negative amortization loans. In 1Q 2006 the company made $203 million (about $0.20 per share).

In an option ARM, the borrower can defer payments. If they choose to defer, the bank (WM and others like Golden West Financial (GDW)) adds the amount to the principal BUT STILL CREDITS THAT AMOUNT TO EARNINGS. This increases the risk dramatically of loans out of control and risks to default.

If we soft land (whatever that is) WM may experience only limited problems. If we go into a recession and as defaults rise all those "earnings" may get unwound and principal write-offs will increase dramatically.

The point is no one is accounting for that risk.

John Succo / Minyanville

Mish:

Also speaking of systemic risk I find the following clip about Fannie Mae and Freddie Mac by Randal K. Quarles Under Secretary for Domestic Finance U.S. Department of the Treasury rather telling.

Secretary Paulson has made it clear to me that he believes there is systemic risk associated with the GSE's retained portfolios. While he shares the view that a legislative outcome is preferable, he has instructed us to ensure that the mechanics of our debt approval process are robust enough to give Treasury the practical option of limiting the GSEs' debt issuance in accordance with our statutory authority should that become necessary. If a legislation solution is not achieved, Treasury will have no choice but to consider additional action.

It seems the Treasury is bound and determined to do something about systemic risk at the GSEs whether Congress acts or not. Given that the government always acts after the cat is out of the bag and the damage already done, it's just a matter of time before we see the fallout from the busting of the housing bubble that GSEs, the administration's "ownership society", and the Fed all acted together to create.

Earlier today Dow Jones sent the following news clip:
08/24 9:13A *DJ Justice Dept Informs Fannie Mae Probe Is Discontinued
That clip does nothing to remove the systemic risk at the GSEs.

Thanks to Professor Succo and Minyanville for today's thought of the day.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/