Short the DeMarco Trade

Or Wall Street Doesn’t understand Washington 

HousingWire and the Wall Street Journal both recently carried articles about the DeMarco Trade. The DeMarco trade is the idea where market participants believe Government Sponsored Enterprise (GSEs) guaranteed mortgage backed securities (MBS) will have a significant increase in prepayments as DeMarco is replaced in the first or second quarter of 2013 and the new Director of Federal Housing Finance Agency will allow immediate principal forgiveness for GSE MBS. The GSEs will cover the losses to investors in the form of immediate principal prepayment. If true then investors should be flocking to Principal Only (PO) or heavily discounted 06-08 vintage GSE MBS.

However, anyone who buys into this trade should 1) have their head examined and 2) learn how the government actually works. The DeMarco trade makes several assumptions which history and facts have proven false over time.

Assumption: The Obama administration anger over DeMarco’s refusal to agree to principal forgiveness makes him an early target for removal.

The Administration, like the GOP, didn’t trust Nat Silver’s statistics and worried how they were doing in the polls. Principal forgiveness seemed like a great idea to help out many struggling homeowners and an economic stimulus without adding to the federal debt thereby generating votes. Based on press at the time, Geithner was especially upset by DeMarco’s resistance to the idea. When DeMarco finally said no after months of delay (or “study as he called it), Treasury retaliated by changing the preferred stock agreement to sweep all of the GSE’s so that they will never leave conservatorship leaving only a path at some time in the future for receivership.

And unlike High School, politicians don’t stay angry when political bigger game is available to hunt.

Moreover, with the election over, President Obama has bigger appointments he needs to worry about including Secretaries of Defense, Treasury, State, Energy, and Commerce and a permanent chair of the SEC.  The fiscal cliff negotiations will determine how many chips he has earned or lost to set up who he nominates for positions. For instance, the GOP helped to kill the Rice nomination for Secretary of State to, hopefully for them, to force Obama to nominate Kerry and thereby allow soon-to-be former GOP senator Scott Brown to reclaim his job.

DeMarco isn’t on his immediate todo list.

Assumption: GOP will roll over on FHFA Director nomination.

Senate GOP are licking their wounds after losing three of their colleagues in the election and are willing to fight to keep DeMarco in office because he helps their agenda (which could change and then they would scream for his removal). As I said Obama has bigger issues to fight than housing. Senator Shelby will very likely repeat his winning performance by blocking any Obama nominated candidate. Senator Shelby enjoys and earns political points at home being the thorn in the side of the Administration especially in his roll as Ranking Member of the Banking, Housing and Urban Affairs Committee.

For those with a sort memory, Obama nominated Joseph Smith, the head of North Carolina’s banking regulator who is widely respected by the industry. Senator Shelby (of Alabama) screamed Mr. Smith was too weak on banks and therefore held up his nomination. Mr. Smith withdrew his name for consideration in frustration. (As an interesting side note,  “the weak” Mr. Smith was chosen by state Attorney Generals to administrate the five bank robo-signing settlement including the one from Alabama in February 2012)

Expect a bruising confirmation should a candidate be nominated.

Assumption: Obama will use a recess appointment to remove DeMarco

Recess appoints are temporary appoints that last only a year or so creating a bruising battle when the next nomination comes up.  Recess appointments are also shut out from getting the position on a permanent basis. Recess political appointees also tend to have a tough time in front of the senate, which has far reaching subpoena powers. If they senate appointments were so easy, more appointees would be in place.

Secondly, GOP has figured out a procedural trick to keep congress open so the President can’t perform a recess appointment without extreme difficulty. The appointment of the Consumer Finance Protection Board director recess appoint was done with significant issues including a lawsuit questioning its legality.  Don’t expect a FHFA recess appointment anytime soon.

Assumption: Obama will appoint him in the first quarter 2013

Not true! With the Mayan Apocalypse occurring 12/21/12, Obama won’t have time to appoint anyone.

Good luck with your trades.

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