Freddie and Fannie May Be Debt-Ridden,
But Their Bonds Are Worth Holding

Central banks are notorious for their ill-timed investments. The latest such trade was conducted by several Chinese banks in August as they reduced their combined positions in Fannie Mae and Freddie Mac debt.

Erring on the side of caution, you can’t blame China’s banks for selling Fannie and Freddie debt. After all, many of these banks have already lost billions betting on global stocks recently, including U.S. banks.

But the timing of the sale is just dead-wrong. Right now, both lenders have the implicit U.S. government guarantee that Freddie and Fannie won’t fail. Plus, Freddie and Fannie have some of the richest spreads versus Treasury bonds in history. Fannie and Freddie bonds have gained 3% in 2008.

If anything, now is the time to buy, not sell, Fannie and Freddie debt. PIMCO is probably the savviest bond investor in the world with more than US$800 billion in assets. Recently, PIMCO has been aggressively accumulating mortgage-backed securities.

Last week, PIMCO announced they may be creating a private fund to buy the highest quality mortgage-backed securities.

China’s recent paring of U.S. GSE (Government Sponsored Enterprises) holdings is not significant considering all positions are valued at less than US$13 billion.

Both mortgage lenders have issued hundreds of billions of dollars in fixed-income securities over the years. China’s slicing of US$23.3 billion on December 31 to US$12.7 billion as of August 25 won’t affect GSE pricing in a big way. The figure is not big enough.

Global central banks - including several Asian and Middle Eastern banks - have a bad track record making investments lately.

Sovereign Wealth Funds, or SWFs, have been aggressively buying distressed U.S. and European financial services companies since the sub-prime market exploded in August 2007. These guys have already lost billions on paper since last fall.

Central banks are also notorious for making the worst investment decisions at the wrong time. Over the last decade a host of central banks have dumped gold just as prices bottomed in the late 1990s.

Are Chinese banks right to reduce GSE holdings this summer? My guess is probably not. I’ll bet on PIMCO.

PIMCO Scoops Fannie and Freddie Debt

Some of the best values now lie in distressed mortgage-backed securities like Fannie Mae and Freddie Mac bonds. PIMCO, the world’s largest bond fund manager with over US$800 billion in assets, has been aggressively accumulating the debt of both lenders.

Credit spreads for government mortgage agency debt have surged over the last few months and now trade at their highest levels in history compared to Treasury bonds. Premiums are now trading at just under 300 basis points or 3%.

The government has already guaranteed that both crisis-plagued mortgage lenders won’t fail. That means Fannie and Freddie debt is cheap at current prices, even though shareholders are likely to get wiped-out if the government eventually nationalizes Fannie and Freddie.

And as the mortgage market goes, so goes the real estate market…

Buying Up Busted Properties

U.S. real estate also offers excellent values, particularly from rising foreclosures and bank repossessions. This is exactly what occurred in the 1989-1991 Savings & Loan crisis. Then several years later, vulture investors earned big profits from buying cheap properties.

In the most devastated real estate markets of Nevada, Arizona, California and Florida, investors can find an abundance of residential and even a growing universe of commercial properties gone bust.

To be sure, financing has grown more difficult for even the most creditworthy of borrowers as banks balk at lending. But many deals will be closed in the coming months and years, as banks grow increasingly desperate to get rid of a truckload of properties at fire-sale prices.

Real estate in the United States is extremely cheap when priced in euro, yen or most other currencies. In 2007, more than 20% of all residential property purchased in Manhattan was by Europeans. I expect that trend to accelerate in 2008, especially if the euro continues to soften.

U.S. Stocks Offer Some of the Best Values in Global Markets –
Especially when Accounting for Currency Changes!

Lastly, U.S. stocks offer big values compared to other markets because of the potential for higher currency-adjusted returns.

Over the last seven years, dollar-based investors have earned big profits in overseas stock markets, using the dollar’s decline to rack up huge currency-adjusted gains in foreign stock prices. But the opposite might occur now similarly to the 1995-1999 period, when U.S. markets outperformed foreign markets.

Therefore, I expect U.S. stocks to finally benefit from a surge in foreign institutional money after years of net outflows. I also think the huge inflows into foreign equity funds will slow markedly over the next 12 months as mutual fund investors redirect capital to domestic funds, which have badly lagged behind other markets.