Fannie, Freddie and America's Debt Load

 
Today we start with a discussion of the U.S. government rescue of Fannie Mae and Freddie Mac, constructing a vision of the big trends that brought us to this place, and where they might lead next.
 
In my vision, it all revolves around debt.

Fannie Mae (officially Federal National Mortgage Association) was founded in 1938, as part of then-President Franklin Delano Roosevelt's New Deal in which government money and reputation helped pull the American economy out of the Great Depression by supporting the mortgage industry.

In 1968, to help balance the federal budget, Fannie Mae was converted to a private corporation, and at that point all guarantees of government backing disappeared.  Technically, the company was no more part of the government than Wal-Mart, Apple or Exxon are today.

In 1970, Freddie Mac (officially Federal Home Loan Mortgage Corporation) was created to expand the market for secondary mortgages.  Like Fannie Mae, it was a private corporation.
 
But investors treated both companies like government-sponsored entities (GSEs), allowing them to function with a far riskier capital/asset ratio than other private companies.

The result: two companies that--in one wag's words--successfully "privatized profit and socialized risk."

America's Debt

What else happened between 1938 until now?

World War II provided a huge shot in the arm to the economy, and after it was over, soldiers borrowed money to buy houses.

The interstate highway system was constructed, and Americans borrowed money so they could drive cars and trucks on it.

Television was invented, followed by VCRs, DVD players, home theater systems and big flat high-definition TVs, and people borrowed money to buy them.

Credit cards were invented, and as they became increasingly socially acceptable, marketers became increasingly skilled at persuading consumers to buy what they couldn't afford.

Higher education became increasingly popular, and as demand grew, the opportunities to postpone paying for it by using both private and government loans multiplied.

And then came the home equity loan, which meant that instead of paying off your house, you could borrow more to reflect the house's increased valuation.

Today the average American lives in a home he doesn't own, and which may be worth less than what he owes on it.  He drives a car he doesn't own, which also may be worth less than he owes on it.  And he owes over $9,000 on his credit cards.  The average college student is $20,000 in debt at graduation.

Did anyone ever counsel that it might be smart to borrow less?  Of course, but self-discipline is no fun, and after all, "everyone was doing it."

Even the U.S. government did it. 

In 1948, the Federal Debt was $252 billion
In 1958, the Federal Debt was $288 billion
In 1968, the Federal Debt was $366 billion
In 1978, the Federal Debt was $830 billion
In 1988, the Federal Debt was $2,867 billion ($2.9 trillion)
In 1998, the Federal Debt was $5,506 billion (5.6 trillion)

And today, in 2008, the Federal Debt is over $9.7 trillion ... and climbing fast.

A few of the latest expenses: Georgia (the one next to Russia) gets $1 billion.  New Orleans and surrounding areas, which have received at least $133 billion since Hurricane Katrina, get some more.  Our remaining domestic automakers may get $25 billion (they first asked for $50 billion) to help make fuel-efficient cars.  And now we have the big question mark of Fannie Mae and Freddie Mac, put under conservatorship without an exit strategy ... or even a game plan!

Ask Bill Belichick, coach of the New England Patriots, what happens if you don't have a game plan.  You lose.

The feds--technically the Federal Housing Finance Agency--have no definition of winning.  They're just hoping that their actions stabilize the industry, and help stop the financial bleeding that has already bankrupted 10 banks and now threatens Lehman Brothers.

I have my doubts.  I think the housing industry peaked in 2006 and that it will be a VERY long time before that peak is exceeded, whatever measure you use.

Demographic trends argue for it; baby boomers (still the biggest generation and thus the most influential) have their houses (many have two) and as they age they will downsize.

Energy costs argue for it.  It costs money to run a house, and higher energy costs mean the costs of owning a house will rise.

Green consciousness argues for it; smaller houses are better for the environment.

And--cycling back to the topic of debt--a couple of major government obligations argue for it.  Here I'm referring to the fact that our government's current liabilities and unfunded entitlement promises add up to $53 trillion, of which $41 trillion consists of obligations to pay for Social Security and Medicare.

$53 trillion is a very big number (nearly four times last year's GDP!) and we can't simply grow ourselves out of it.  We've got to make some hard decisions--just like many American households do every day--about cutting expenses ... and the sooner the better.  We've probably got to raise taxes, too.

Shrinking Debt Bubble

To learn more about this, you could see the movie "I.O.U.S.A."  You could read the two-page ad in last Sunday's New York Times, paid for by the Peter G. Peterson Foundation.  Or you could go online to http://www.pgpf.org

And after you do you should talk to a politician, because the majority of our politicians--if they acknowledge the problem at all--refuse to talk about it, and the longer they delay, the more it's going to hurt.

Eventually the problem will be addressed, because our national debt just can't grow forever.  Our creditors--China and Japan together own roughly 47% of our national debt--won't let it!

In my mind, just as the failure of the sub-prime market triggered the collapse of the housing industry, the collapse of the housing industry will trigger the deflation of our debt bubble.  Eventually, if all goes well, the end result will be a smaller debt load for the U.S. and a smaller debt load for American consumers as well ... which in my mind means living in houses we can afford.

Now, I admit that I'm going out on a limb here, but I know that in the stock market when trends run to extremes, the ensuing corrective actions persist far longer and further than anyone anticipates. So why not in the credit market as well?  Why shouldn't our debt bubble shrink as we restore our balance sheets--both personal and federal--to more sane levels?

And as our debt bubble shrinks, a process that in my mind should go on for decades, I ask what the American financial landscape might look like in the decades ahead.

Imagine if there were a national consensus that shrinking debt would help save America.

Our representatives in Washington would cut spending and raise revenues, through higher taxes and perhaps even asset sales.  Individual Americans too, would cut spending.  Health care costs would stop their steep ascent.  Savings rates would grow, and there would once again be more focus on earning interest than paying it.

Borrowing rates would fall, and the remaining lenders would compete hard for a share of the shrinking pie by lowering interest rates.

Unfortunately, all that reduced spending might mean that GNP would fall, too ... and we've been taught that recessions are bad.  But in a new reality where reducing debt is paramount, might that perception shift?

If we can all agree that living within one's means is better for the average American, then why not for America as a whole?  Why can't improving our national balance sheet, and getting control of our finances, be as important as growing?  With creditors like China and Japan, we may have no option.

I welcome your opinions.

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Today's investment idea ties into that possible new world, specifically the part where health care costs are brought under control.  It's CVS Caremark (CVS), which will be the country's largest drug store chain once it completes the acquisition of Longs Drug Stores.

The stock was recently recommend by J. Royden Ward, editor of Cabot Benjamin Graham Value Letter, who wrote the following:

"CVS shares are undervalued and sell for only 13.5 times forward EPS.  The 10-year average P/E for CVS is over 20.  We expect CVS shares to advance to our Minimum Sell Price of 56.19 within one to two years."

"The management team at CVS has created a formula for success that is producing superior sales and earnings growth.  Sales increased by 25% and EPS jumped 28% during the first half of 2008.  We expect future earnings growth of 17% during the next three to five years, as a result of cost savings from present and future acquisitions.  Growth in the health care sector, aided by the aging baby-boom generation, should provide CVS with an additional boost."

I look at the company and I see a perfect track record of revenue growth over the past decade and a near-perfect track record of earnings growth.  Debt is reasonable, and the company pays a dividend that amounts to 0.8% annually.

Fundamentally, I think the company's MinuteClinics, which offer many basic medical services for far less expense and hassle than hospitals, have huge growth potential.  I also think the company can be a key to controlling our national health care costs if it takes a proactive approach to keeping Americans healthy instead of treating them after they get sick.

Technically, I see a stock in a solid long-term uptrend that has recently pulled back from 44 in June to a double bottom at 36 in July and September.  It looks attractive right here ... for long-term investors.

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Editor's Note: CVS Caremark may not appear here again but it will be mentioned in every issue of Cabot Benjamin Graham Value Letter until Roy Ward recommends selling.  An important feature of the newsletter is the Maximum Buy Price and the Minimum Sell Price, which are provided for 250 quality stocks in every issue.  If you're in the market for value stocks, there's no better advisory than Cabot Benjamin Graham Value Letter, and there's no better time to begin than now, when stocks are cheap!  To get started with your no-risk trial subscription, simply click the link below.

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Yours in pursuit of wisdom and wealth,

Timothy Lutts
Publisher
Cabot Wealth Advisory

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