Fair Value, Insolvency and Stock Prices

Is anyone else somewhat baffled by the latest concern about the solvency of Freddie Mac and Fannie Mae and the resulting impact to its stock price? Where was all this concern back in the highs of the dot-com bubble? Those companies were most certainly insolvent - besides the cash infusions they were getting, they had zero revenues and their assets consisted, for the most part, of instantly obsolete computer hardware. So, then, why is it then that Fannie Mae's and Freddie Mac's solvency is now such headline-making news and, apparently, the basis for its volatile stock price?

It ultimately must come down to future expectations. Dot-com stock prices rose because the expected earnings of those companies continued to rise - regardless of whether those expectations are well founded. Consequently, then, it would seem as though the markets are now implying that neither Fannie or Freddie would be able to meet its debt obligations with the lower future expected revenues on the depreciating assets that it still holds. Of course, when you add-in the guarantee of the government, this adds a whole new dynamic to the mix. With that guarantee, the earnings of these two institutions become almost secondary as the government could always, then, step-in to satisfy any claims when they arose. The question remains, however, why the question over its solvency continues to be such a significant question mark.

Could it be that the markets have learned their lessons from the dot-com era and are now looking at the balance sheets of the companies in which they invest ...before they invest? It's possible, to some extent, but I think that it's actually more likely that this is just another example of the markets grabbing onto any kind of headline-making news to justify trades in either direction. Speculators, making profits on their short sales and derivative positions love volatility and Freddie and Fannie have been their best friends lately. A savvy investors should, on the other hand, question the headlines as to what actual news they reveal. Nothing had changed since the week prior to these solvency headlines to today; the only revelation was that the financial journalists decided that it was now news. Was it because they didn't have anything else to write about? Maybe more simply, questioning a company's solvency sells papers and sells TV ads. As an investor, of course, you need to question the value of that information.

Common Sense that's not so Common

If there is a silver lining to the current state of the financial markets it's that many of the events of the past few months will serve to fill a whole new generation of economic and financial textbooks - education future analysts and managers on what not to do. Last week, IndyMac became the second largest financial institution to be seized by the Federal Deposit Insurance Corporation (FDIC) after a run on the bank left it short on cash. Having seen its stock price fall from a peak of $50.11 in mid 2006 to a closing price of $0.28 on July 11, it certainly looked as though the markets could see what was coming, so why didn't the bank's managers?

IndyMac was, not surprisingly, [too] heavily involved in the so-called Alt-A mortgages and, of those mortgages, [too] heavily concentrated in California - the second worst hit real estate market in the U.S. Many now suggest that IndyMac could have avoided its collapse by altering its business practices when it began to see a peak in the real estate markets; of course, hindsight is 20-20 and we all seem wiser after the fact. That said, one of the first things that anyone learns when studying finance is diversification; how can the leaders of financial institutions like Bears Stearn and now IndyMac be so complacent in their responsibilities to diversify their businesses? 

Even if you don't know anything about investing, you've probably heard the saying 'not to put all your eggs in one basket'. I personally don't believe that IndyMac could have fairly spotted a market peak and adjusted its business accordingly. I do believe that the use of not-so-common common sense could have very well avoided its collapse. Every market goes through cycles and investing too heavily in just one such market exposes you to those cycles. Diversification is your safety net by compensating you for losses in one market with gains in another; it's so simple. Personally, the management of firms who don't exercise this common principle should be punished in some way - it should not be the federal government (and tax payers, by corollary) who should be held responsible in such circumstances.

What a roller coaster for Fannie and Freddie

Well, if you haven't heard about the roller coaster ride taken by Fannie Mae and Freddie Mac in the markets this week, then try this on for size. How about loosing 50% in its market cap in a matter of hours and then recovering to a loss of about 5% by the end of the same trading day. Then, of course, you must has what triggered all that volatility. The answer, unfortunately, doesn't exactly inspire a lot of confidence in the financial markets.

It comes down to your definition and interpretation of the government's guarantee of both Fannie and Freddie and, more simply, rumours and speculation. Rumours, probably more than anything, caused the massive swings. Rumours about both the institutions' abilities to raise capital as well as about what the government would do, exactly, to help protect investors. Secondly, there is now even more speculation about what any government support would mean for the U.S. government as a whole and how that could even more broadly affect America's financial markets and the continuing credit crisis.

With the Fed's credit window now opened to both Freddie and Fannie, many of the concerns have been calmed. As I write this post, actually, Freddie and Fannie are reallying - up almost double digits today. Nothing has changed, of course, from yesterday so your guess as to the cause of this rally is as good as anyone else's. That's the real problem; there's so much uncertainty that investors, and the markets as a whole, are too eager to grab on to any positive news and trade the hell out of it. If you've ever studied finance, then you'll remember reading about the efficiency of markets; the activity in Freddie and Fannie over the past month will no doubt go down in textbook history as an example of how inefficient the markets can be. 

Freddie, Fannie and Implicit Federal Guarantees

Freddie Mac and Fannie Mae have, between them, the worst of jobs in this particular market: making the mortgage loans that every other bank is running away from ...fast. Between these two companies, they guarantee about $12 trillion in loans. Yes, that's a 't'. What's curious about the current situation, however, is that although these two companies have the implicit guarantee of the federal government, the open market seems to have placed some question on whether that federal government would actually step-up when the time comes... as it may very well come.

Today, there's even a question of the companies' solvency. Solvency, as you know, represents a company's ability to repay all its creditors after liquidating all its assets. Consequently, there seems to be some question as to whether the assets of Freddie and Fannie actually outweigh the massive debts it now holds. Of course, with a guarantee from the Federal government, there would be no worry as the government could always, theoretically, print money to pay every one back. With the staggering sums at stake, however, some are questioning whether they will do so. How do we know that they're questioning this? Simple. Look at the premium that Freddie Mac just paid on its latest $3 billion debt issue - almost 3-quarters of a percent over the U.S. Treasury rate. That premium is a risk premium, of course.

One could, of course, take the opposite position on this and reap the rewards should the market have overreacted. The consequences of allowing Freddie and Fannie fail would overwhelm anything that could have happened from the failure of an investment bank such as Bears Strean, which the Fed has obviously stated could not fail. Similarly, then, Freddie and Fannie cannot fail. As such, the markets certainly appear to have seriously overreacted on their risk asssessment of these two companies. An investor prepared to take this leap of faith, however, could benefit from a staggering medium-term return should the Fed make its implicit guarantee explicit. So, where do you stand?

Competition & Deregulation Fight Stagflation Part 2

Sometimes it seems as though there's a counter-argument for every argument; isn't it great! I just finished writing how competition and deregulation was working to prevent inflationary pressures from spiraling out of control and then I read this article that made me rethink my position, again. I still believe that competition and deregulation are in-fact working to keep those pressures under control, but I neglected to consider the effects of rising fuel prices on the extent to which that competition can take place.

There's no doubt that communications technologies enable for a great deal of competition in the services sectors, but that's going to have a lot less of an impact on the manufacturing side of the economy. Ultimately, manufacturers have too get their goods into a market before they can sell them there and the rising cost of oil has made that far more expensive. The result is that domestically produced goods are just a little more attractive and the demand for those goods, as a consequence, is just a little higher. This higher demand for domestic manufacturing empowers laborers just a little more and makes wage-hikes just that much more likely. As I've written before, rising wages is the key influential factor driving inflation.

So where do the scales balance? Good question; it's anyone's guess really. I will say that the forces of competition and deregulation are not going away, but the oil price bubble may very well disappear. What happens then?

Competition & Deregulation Fight Stagflation

I just finished reading an interesting article that has caused me to rethink my position on the state of the economy and where it may be going. I've written before on how the current slowdown resembles what we saw in the '70s and earl '80s, but after reading this article, I'm reconsidering the affects that global competition may have on the ability of the U.S. economy to ever see the sort of rocketing inflation that we say a few decades ago.

It comes down to wages. If wages don't begin to rise (accelerate, actually), then inflation will remain relatively under control. This is an important fact to remember when you consider that a global economy means that nearly every sector, industry and individual business competes with international vendors willing to cut prices and snatch-away customers. The article uses the airline industry as an example, but the same logic could be extended to almost any market. Whereas airline ticket prices rose by more than one-third in the early '80s, they've seen less than a 2% rise even with the unprecedented rise in the cost of fuel. The reason? Competition and deregulation.

There are more airlines, even with all the trouble in the sector, than ever before. Travelers have more choice than ever before. The result is that airlines are left sitting between a rock and a hard place. With the rising cost of inputs to their operations, the decision is no longer whether or not to raise prices, but rather whether or not to continue operations at all. They are no longer able to raise prices because their competition won't. One of any competitor airlines that had been fortunate enough to hedge the cost of fuel earlier will have a cost advantage and will simply assume all customers should its competitors increase their prices. In economic terms, it suggests an inelastic short-term supply curve. What's interesting about this argument is that nowhere have I mentioned wages, which is traditionally considered to be the primary driver of inflationary pressure.

There's competition for jobs too. Just like there are more airlines fighting over travelers, there are more people fighting over jobs. Workers are less able than ever before to request a wage increase. There are fewer labour unions and those that do still exist are less powerful. Moreover, the ability to outsource leaves employers not with the decision to increase wages or lose employees, but rather whether or not to keep employees or outsource operations oversees where costs could be a fraction of what they are locally. The consequence of all this is that rapidly rising inflation may really be a historical artifact.

CDSs & Counterparty Risk; What Every Investor Should Know

Credit Default Swaps (CDSs) are making headlines these days, and not for good reasons. CDSs are essentially insurance contracts on debts - investors buy them to protect their income streams and principal investments in debentures should the issuing party default on their obligations. Most notable of these almost-defaults, of course, has been Bear Stearns and CDSs have been in the headlines ever since.

Why do you care? Well, would you believet that CDSs are unregulated and that there's no public record of the sellers solvency should they actually have to deliver on the contracts they sell. As an investor, this should scare you to death. Think about it this way: imagine you paid into your insurance policy, for your car, your home or even  your life, and when the worst actually happened, the insurance company just disappeared; this is the situation that may very well still happen. Yes, still; we're not out of the woods by any extent.

George Soros has been one of the most outspoken investors on the subject of how "unacceptable" it is to have a market such as this develop in an unregulated fashion. Now representing as much as $62 trillion in contracts, the collapse of such a market could mean worldwide financial fallout. This is no joke folks.

How's this for a revelation. JPMorgan is not only the investor of these types of contracts, but is also one of its biggest issuing firms (i.e. counterparties). Unlike traditional insurance companies, there is no agency that monitors the sellers of swap contracts. What makes things even more interesting, you don't even have to own the asset that you want to protect when you buy the swaps. Yes, that's like buying a life insurance policy on someone else - could you imagine if that were possible and what sort of practices that would condone?

LIBOR - The London Interbank Offered Rate

The London Interbank Offered Rate, also known as the LIBOR for short, is a daily reference rate at which banks offer to lend unsecured funds to other banks - specifically on London's money market. The LIBOR, however, is used all over the world as the basis for many securities that return a variable rate of return. Why is all this important or interesting? Well, the way it is calculated has come under attack in recent years and that model may very well be changing as a result.

The non-governmental British Bankers Association (BBA) that sets the LIBOR does so by first collecting reports from its member banks. These banks report what their costs of borrowing are to the association which are then figured into an average for use by all banks as their reference rate - the basis on which they offer funds to business and individuals for anything from mortgages to company lines of credit. In recent years, however, there has been mounting speculation that the member banks reporting their borrowing costs have been fibbing - under-reporting so as to keep their own borrowing costs lower.

With the slowing world economy and continued concerns over credit availability for many financial institutions - not exclusively those in the United States - interest rates are expected to begin to rise. Just as this means our own cost of borrowing on car and school loans will begin to tick upward, the big banks are concerned that their own costs will rise. Having issued much of their recent loans at the presiding low rates and many still saddled with quickly depreciating assets, this does not paint a rosy picture for banks as an industry. Of course, it's hard to see how this is any justification for manipulating the system for their own benefit.

As with CDOs, default swaps and mortgage-back securities, it's important for any investor to understand exactly what it is that they're buying when they invest their savings. The LIBOR is one of those elements that many of us likely take for granted, but this too should be a factor in our investment decisions. Understanding that the LIBOR is a manufactured entity should spur our own questioning of its validity and interest in alternatives - and there are many. The Fed Funds Rate, the Treasury Bills rate (for the relevant maturity, of course) or even your own banks prime rate. Consider the alternatives; talk with your bank managers and choose a reference rate with which you feel comfortable will provide you with an accurate representation of the cost paid by banks - the cost that they will the pass along to you.

Never mind a cut to 2%, how about a hike to 2.50%

On Wednesday this week, the Federal Reserve, headed by Ben Bernanke, will meet to decide the fate of interest rates for the next six weeks. The rate currently sits at 2.25% - 3% lower than it was just nine-months ago. Mr. Bernanke and the Fed have been very aggressive with their cuts to help keep the economy out of a recession. Today, however, with most people agreeing that the economy is already in a recession, what should the Fed do next? More importantly, with inflation concerns higher than ever, a further attempt by the Fed to keep this recession as mild as possible could come at an incredible cost a year from now.

The rising cost of fuel and, more recently, commodity prices have made living expenses rise for the average consumer. The Fed hasn't helped either. The lower interest rates have caused the American dollar to sink against the Euro and other currencies - as much as 7%! This too has caused import prices more expensive and driven-up costs for consumers. All these rising prices mean one thing: inflationary pressures.

Today's economy is being compared to that of the late 70s and early 80s more than ever. A lot of people are beginning to foresee high inflation. The only thing that has helped the Fed, and the economy, is the general believe by the American people that the Fed is doing (and will continue to do) all that it can to keep inflation under control. This belief may quickly vanish, however, if the Fed doesn't begin to deliver on those expectations. Why care?

If inflation does start to creep-up like a lot of people believe that it will, then it will need to eventually be brought under control by the Federal Reserve. In the 80s, Paul Volcker, then Fed Chairman, pushed interest rates up to the high-teens in order to bring inflation back from its double-digit levels. This, of course, sent the economy into a VERY deep recession. If Mr. Bernanke isn't careful, his successor will need to do the same thing because he'll certainly be out of a job.

As speculation mounts over whether the Fed's meeting will result in a quarter percentage point cut to 2% or stay-the-course at 2.25%, maybe the Fed should rather be considering a quarter-point hike!

Is there really a difference between 2.25% and 2.00%

Ok, so I studied finance and I know that there is a 25-basis-point difference, but I think that you and I both know that that's not what I meant.

The Fed (the U.S. Federal Reserve Bank), via the open market operations, helps to manage the swings in the business cycle by monitoring various economic indicators and pulling various levers to flatten-out the bumps. One of these levers, the most important one actually, is the interest rate (the Fed Funds Rate, to be precise).

When the Fed reduces the interest rate, it makes money cheaper - it makes borrowing money less expensive because those who do borrow, pay less interest. You have to ask yourself, however, whether a 0.25% further reduction in the interest rate will stimulate those who have been holding-off on an investment decision (like buying a home or expanding business operations) to suddenly make the leap. The answer is likely no.

The Fed's actions are likely less important that the reasons for its actions. People watch the Fed to learn of what top economic minds think the economy will do next (or what it's doing now). With almost 300-basis-points down in the last 9-months, I think that we all can accept that the Fed and all those economic brains think that the economy needs help. We got the message, trust me. Sending the rate lower yet will not drive-home that message any further; moreover, it could cause problems for the Fed in the medium term should it really need to pull on that lever harder, later. It's going to be interesting to see what the Fed chooses to do; it will be more interesting to see if the markets react at all to whatever it is that they do choose to do!