The saga of the big US, government-sponsored mortgage lenders has fired up CLSA’s Christopher Wood this week. In the latest issue of his client newsletter Greed & Fear, Wood muses over the recent “spectacular” declines in the share prices of Fannie Mae and Freddie Mac (latest news in the FT, here and here).

The federal mortgage agencies are a “bizarre mix of private- and public-sector incentives”, says Wood. “They have long borrowed money with an implicit federal government guarantee which investors tend to assume have made their bonds the equivalent of higher yielding Treasury bonds”.

If the mortgage agencies played a key role in keeping the US consumer going in the wake of the collapse in US capital spending after the Nasdaq bust, they have been “brought to heel” in recent years by sensible regulation from the Bush administration. This has required them to submit to much stricter capital requirements, notes Wood.

The US private-sector mortgage machine, however, is imploding. The question has now become whether the mortgage agencies will be able to take up the slack. The problem, in Wood’s view, is that the mortgage agencies are themselves the victims of the spreading financial problems in the mortgage market.

There is every chance that equity can be raised by the mortgage agencies if markets want to rally. Still a likely further deterioration in the housing market could prove to be the catalyst for an accelerating taxpayer-financed recapitalisation of the mortgage agencies, or even outright nationalisation via the establishment of an explicit guarantee from the Treasury.

The authorities would be forced to act fast if there is any real problem on Fannie’s and Freddie’s solvency because otherwise the system could freeze up. Such a Treasury financed bailout would only be politically conceivable in the event of a crisis which implies much lower share prices nearer term. It also implies shareholders in Fannie and Freddie being wiped out.

The US mortgage agencies are still highly leveraged. They are clearly vulnerable to the risk posed by falling house prices as delinquency problems move from the subprime and Alt-A areas into even prime mortgages.

The escalating weakness in US housing also means that the action will increasingly be moving from Wall Street to Washington in terms of potential market-moving policy responses, notes Wood. For now, Congress remains caught up in the problem of how to help borrowers without bailing out the subprime lenders.

Sentiment on the dollar, meanwhile, remains “super bearish”. Still there is a growing risk of a sharp US dollar rally if the markets suddenly wake up to the reality that the global economy has not yet completely decoupled from the US consumer. “In this respect, the euro looks as extended a currency as any, though sterling is another obvious area of extreme vulnerability.”

Slowing growth in Euroland, in Wood’s view, is “surely inevitable, as also is ECB monetary easing”.

Still the slowdown will naturally bring to the fore simmering politician tensions in Euroland between the contrasting needs of Germany and the vulnerable consumer debt-driven economies like Spain and Ireland. Ultimately, monetary policy is likely to be run in the interests of the weakest constituents. This means aggressive rate cuts and a much weaker euro.

The key tactical point to note now is that buying the euro against the dollar is not a risk-free trade. A much better currency trade is to buy the Singapore dollar and sell the euro. Investors should also be aware of the potential short squeeze on the dollar as investors seek to buy back borrowed dollars.

And in his romp around the world, Wood alights on the bond market, where he describes action as “scarily deflationary”. This makes Wood even more wary of cyclicals geared to external demand in the context of an Asian-equity portfolio. It is also the case that where domestic cyclicals are owned, the place to own them in his view is primarily in India.

It remains a reality that Asia as an asset class is cyclical by nature, notes Wood.

There will clearly be collateral damage in Asian markets if the American slowdown isas severe as suggested by the recent US bond-market rally. But the key long-term point to remember is that Asia and emerging markets will be the next bubble to form globally from the current Fed-easing cycle, which has much further to run. It would seem that 2 per cent is a good place to start for where the fed funds rate is ultimately going to end up in this easing cycle.

This entry was posted by Gwen Robinson on Friday, November 30th, 2007 at 13:30 and is filed under Capital markets. Edit this entry.