Home > The Merk Perspective > Merk Insights > August 24, 2010

U.S. Dollar Threatened by Fannie & Freddie

Axel Merk, Portfolio Manager, Merk Mutual Funds

August 24, 2010

Social subsidies may make good politics, but all too often bad economics. When Fannie Mae was created in 1938, the seeds were planted for the biggest housing bust the world has ever seen; the going was good while the party lasted for the first 80 years, but ended in the financial crisis of 2008 – the hangover for many still remains. In 2008, many feared the dollar might collapse should Fannie Mae and its smaller cousin Freddie Mac (together here Government Sponsored Entities or GSEs) fail; little did those so fearful know that the government would embark on the largest bailout in history; the U.S. dollar rallied as the GSEs were put into conservatorship, making the previous implicit government guarantee just about as explicit as is possible.

 

   
 

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Now, it appears the proposed “reform” of these entities only has stakeholders in the status quo; we are concerned this may ultimately open old wounds, and next time, the U.S. dollar may not be bailed out again. While the focus in recent months has been on challenges in the eurozone, investors tend to forget that the origin of the crisis was ultimately the U.S. housing market. While the rest of the world may have bought bad securities and structural deficits may be prevalent elsewhere, it is the U.S. where “Patient Zero” lives. The problem is, there are still millions of them. While financial institutions around the world are recapitalizing and governments are addressing their structural deficits (some better than others), policy makers in the U.S. are fighting the patients’ symptoms without offering a cure. Moreover, the U.S. is not addressing its own structural deficit, increasing the risk that the deficit virus the U.S. dollar is affected with morphs into a full blown disease that includes a tumbling currency and inflation as side effects. Don’t expect to have another 80 years to prepare for this potential crisis.

We have lived with the GSEs for such a long time that we can barely imagine a life without them. How weird for a country that has historically boasted the freest markets in the world: the mere existence of GSEs resembles more of a planned economy approach. Here’s the first problem with subsidizing housing for the masses: depending on the economic environment and perceived future income potential, rational home buyers allocate a certain percentage of their income to service a mortgage. If the government comes in to subsidize homebuyers, all those receiving the subsidy can afford to pay more. Over time, the subsidy will translate into higher home prices, thus eroding the benefit the policy originally intended to achieve. It is not surprising that the GSEs have gradually increased the mortgage amounts they are subsidizing. The GSEs are not all that different from a government run Ponzi scheme; and all existing homeowners have a vested interest in keeping the scheme running. That doesn’t make it right.

It is important to acknowledge that GSEs are fundamentally ill conceived. Without subsidies, home prices may fall – that’s correct. But that will make homes more affordable!!! Policy makers don’t seem to be interested in affordable home prices, but in the short-sighted belief that preserving the value of overpriced homes through government interference will get them re-elected.


Axel Merk's book, Sustainable Wealth: Achieve Financial Security in a Volatile World of Debt and Consumption is available now.


Some argue that eliminating the GSEs would cause havoc, as the private sector cannot support a market in secondary mortgages; they cite the crisis of 2008 as proof. We would like to point out that not only is there a market for jumbo mortgages, i.e. private sector mortgages too large to qualify for a GSE subsidy, but, when the GSEs were restricted in the amount of mortgages they were allowed to issue due to accounting irregularities last decade, the private sector was able to pick up the slack, without significant additional increases in mortgage rates.

   
 

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More importantly, however, and not so surprising, is that the private sector seizes up when a Ponzi scheme comes to a halt; rather than unwinding the GSEs, the government opted to keep the scheme running. By all means, when the government competes on terms no private entity can possibly compete with, the private sector simply cannot compete. It’s been a hallmark of the bailout era that intervention, whether through fiscal or monetary stimuli, has been able to substitute rather than encourage private sector activity. In that context, it should be noted that the banking sector (AIG, an insurance firm rather than a bank being an exception) has paid back loans from the government. General Motors has not paid back its debt. And the GSEs have cost taxpayers over $150 billion since the onset of the crisis, with at least another $150 billion in taxpayer cost in the pipeline using conservative estimates projecting positive economic growth. We are not suggesting the banking sector shares no blame for the financial crisis, but in our opinion, it makes bad economic policy to throw the baby out with the bathwater.

Eliminating the GSEs right away would indeed cause disruptions in the markets. To get the private sector more actively involved, a clear policy should be set to phase the GSEs out over, say, 10 years. The U.S. economy will be far healthier when homeowners pay a market-based price for their mortgage, rather than a price heavily influenced by bureaucrats.

In the absence of phasing out the GSEs, government obligations will pile up at an even faster pace, making it ever more difficult to address the major structural deficit challenges the U.S. is facing. Fixing the GSEs requires political leadership – apparently nowhere to be seen on either side of the political aisle. If recent history is any guide, we may get a “reform” after a lot of wrangling; one that’s thousands of pages long, creates new bureaucracies, but does not cure the ills that got us into the mess in the first place. We are also concerned that the Fed may just be all too willing to print money in an effort to keep the party going. The U.S. dollar may be the valve that breaks, suffering as a result of these policies. It’s not too late to diversify to take this scenario into account.

We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.

Axel Merk

Merk Investments, manager of the Merk Hard, Asian and Absolute Return Currency Funds, www.merkfunds.com

The Merk Absolute Return Currency Fund seeks to generate positive absolute returns by investing in currencies. The Fund is a pure-play on currencies, aiming to profit regardless of the direction of the U.S. dollar or traditional asset classes.

The Merk Asian Currency Fund seeks to profit from a rise in Asian currencies versus the U.S. dollar. The Fund typically invests in a basket of Asian currencies that may include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund seeks to profit from a rise in hard currencies versus the U.S. dollar. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfunds.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfunds.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invest in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds own and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

This report was prepared by Merk Investments LLC, and reflects the current opinion of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advice. Foreside Fund Services, LLC, distributor.

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