We've Only Seen One-Third of Writedowns?

According to John Paulson, founder of the hedge fund company Paulson & Co., global writedowns stemming from the credit crisis may top $1.3 trillion, surpassing the International Monetary Fund's estimate of $945 billion. Who is Paulson, you ask? He's the guy who placed a bet on the speculative bubble in the sub-prime lending market, which has netted his fund a gain of a whopping 591% in the past year. This is the guy who saw the storm coming so you could say that he's got a fairly good insight into the breadth and depth of the sub-prime market.

$1.3 trillion in writedowns is three-times higher than the writedowns already reported. That's both a staggering total figure and worrying prediction for what the future holds for the global economy and financial markets. The U.S. economy has certainly taken the brunt of the immediate downturn, but as economic speculators are working diligently to maintain a positive attitude in the business press, the reality is that the downturn we've seen thus far is only the tip of the proverbial iceberg.

In a survey of hedge fund managers conducted at a meeting in Monaco last week, more than 80% said that the see the current credit crisis persisting for some time yet so Mr. Paulson is certainly in good company. Moreover, as much as 23% of those surveyed see the current situation worsening further before it gets better. What's interesting, is that it appears that these same hedge fund managers are watching the financial stocks like vultures circling; they waiting for the best time to buy the stocks that have been beaten-down by as much as half. If you're anything like me, then you will be watching the actions of these firms to insights into when, exactly, will be the right time to jump back into the banking waters where the opportunity appears to be astronomical.

How Temporary is 'Temporary'?

Freddie Mac, the government-chartered mortgage financier has had its accountants label approximately $32.4 billion worth of losses as temporary, allowing it to keep the associated losses off its income statement. With those losses representing as much as 20% declines in the face value of the mortgages, these losses would be the biggest ever experienced by the company. One has to ask, therefore, how long is temporary and when will these write downs come, if ever?

According to generally accepted accounting principles, Freddie can get away with this for as long as the rules are changed. What's really scary about this is the magnitude of the losses that are being hidden from investors relative to the company's assets. $32.4 billion is more than double its $16 billion in shareholders' equity and almost equally outweighing its market capitalization. Compared to its net assets of NEGATIVE $5.1 billion, the comparison is just laughable. If you were in this position, you would have gone bankrupt long-ago.

Fannie Mae, Freddie's big sister, is in a similar position, albeit to a lesser extent, with $9.3 billion in such losses. Of course, both these companies are betting on a market turnaround, which would see the underlying assets appreciate and eliminate the losses that they refuse to realize. That said, anyone who's owned a home knows that this appreciation can take many years and neither Freddie or Fannie have included anything in the notes to their financial statements indicating what their own expectations are for these reversals.

It's just a loop-hole and it will be closed sooner or later - forcing these firms to face the music. The reality, however, is that facing the music earlier in the process could have prevented much of what they're now trying to hide. Marking-to-market would have forced the firms to acknowledge the losses as soon as they started to appear and would have likewise forced them to make adjustments to their practices and strategies to compensate for those losses. The capital markets are a great motivator for management to do their jobs well; if they don't, they get fired by their boards who in-turn represent the shareholders.

Auction-rate bonds & Sub-prime loans; Deja-Vu anyone?

I have to admit that I wasn't familiar with auction-rate securities shortly before writing this post. From the news reports now filling the pages of many online financial news sites, it would seem that I wasn't alone. Of course, as with the sub-prime loans, the lack of understanding didn't seem to stop many from buying into these products.

One can't help but recite Mr. Warren Buffett's mantra: invest in what you know.

Auction-rate securities offer borrowers seeking long-term capital the opportunity to pay only short-term rates. Sounds ideal, right? You get money for as long as 40-years, but don't have to pay the premiums that would generally go along with such a maturity. This is possible because of the 'auction' in auction-rate. Specifically, as often as every 7-days, the interest rate cost on these securities are reset in a dutch auction. So, for those buying the securities, it's very much like buying short-term debt. Of course, as you might have guessed, there is a catch.

Unlike Treasury bills or investing in short-term money market funds, investors who purchase these auction-rate securities are essentially buying long-term debt (yes, like 40-years), but with the expectation that they'll be able to hand-them-off at the next auction. You have to ask yourself, then, what happens no other buyers show-up at the next auction? You guessed it, you get to keep those bonds. For individuals and institutions that purchased these securities because they were short-term, this could spell disaster if the funds were expected to be liquid to satisfy some other obligations.

It's not all bad news, if you have some other flexibility in your portfolio. There are penalties when the auctions fail; if you happen to be one of the owners of these little-understood securities and can manage to make-do when the auction fails, your return can shoot-up to as much as 20% on an annualized basis. That ain't bad when the banks are offering you less than 1% for short-term, liquid, savings accounts.

Of course, it's hard to think about the other side of the table - the institutions that sold these securities and are now forced to pay those double-digit rates.

At the end of the day, Mr. Buffett's wisdom certainly does shine-through. It's so simple. Invest in what you know and in what you understand. As an investor you have to appreciate that your broker is a salesman; he or she makes their money by selling securities to you. When they offer you a product that is unknown to you, then take the time to quiz them on the details. If they aren't able to answer your questions, then that should tell you something. If they aren't willing to explain them, then just get a new broker.

Vallejo, California's Bankruptcy 'Unrelated' to Sub-Prime Lending?

Yesterday's big economic news, as far as I'm concerned, was that a town in California would be filing for bankruptcy. As the announcers were saying it, they adamantly followed-up each and every statement clarifying that this was not the result of the wide-spread sub-prime lending problems plaguing the rest of the country. ...how is this not related? Who are they kidding?

I'm the first to support the notion that the government, via the media, should do what it can to keep confidence levels up and maintain positive future prospects among the citizenry. That said, there's a point at which doing so can be more harmful than good. This is one of those moments.

People are funny. They watch the news in segments - disconnected segments. In one segment, an economist will be warning people of rising unemployment, growing concerns over inflation and work diligently to avoid saying the R-word (recession). In the very next segment, albeit after a regularly scheduled commercial break, the well-dressed financiers will excite everyone while quoting statistics from the latest rally sparked by news of higher sales volumes. How is it that no one connects the two segments to provide people with a more complete picture of what's going on in America?

Rising sales - sure, it's possible. Of course, the question is how are those sales being financed? With interest rates at 2%, I bet that you could guess! With the decline of home values to record lows, the average person's wealth has diminished dramatically. All the while, these same people are taking-on more and more debt, forgetting that unemployment is rising and their job security may not be there a month or week later. Then, ask yourself what happens when those individuals and families with all that debt lose their jobs and have zero (or negative) home equity. What happens to those individuals and families when interest rates begin to rise again and the cost of all that debt increases on them? I bet you could guess that too...