Digital Thoughts - Market Mayhem Part II

Market Mayhem Part II

by Editor

Here's what we learned in Part 1, and we'll start with the bad news. If the past twelve years have taught us anything, the rockiness we have experienced this year might only be the beginning. That won't surprise many people, as most people have heard the news or at least friend of a friend predictions calling for a soft domestic economic environment for this year and well into next year. The markets, though, if they act as they have in the past might take even longer before the next period of sustained growth. The good news, if it can be called good news, is that everything occurring today, makes a lot of sense. And, while this might be a crude example, it illustrates the state of the market. If you smoke and get emphysema, you might find yourself disappointed and utterly distraught, but you won't be surprised. For you smokers out here, we'll say it in the other order to make it sound a little more understanding. If you meet someone with emphysema and learn that they smoked, you don't find yourself shocked at the news. Such is the state of the US economy. Fortunately, though, this illness shouldn't prove terminal, and it was in this wild week that we started to see perhaps the first real sign of life as the proverbial shoe fell. And like a lot of things, the waiting and uncertainty was the hardest part.

Not So Big "Mac"
The news that came out last Friday, July 11, might have sounded familiar to many of our parents and grandparents, but it is the first time that many of those in their 20's and 30's have ever experienced such a thing - an insured bank going out of business. It was seized by Office of Thrift Supervision and placed under conservatorship by the Federal Deposit Insurance Corp at the end of last week, and those living in an area with an IndyMac branch who hadn't read the news Friday would have walked by and wondered what to make of the lines 100 people deep. As one passerby who hadn't read the news said, "I thought they were in line for the new iPhone from the AT&T store next door." These patrons weren't looking to spend money but to withdraw funds, many in a panic thinking that their life savings wouldn't be recovered. Fortunately for the vast majority of the customers, the fail safe put in place after a large scale run on banks during the Great Depression means they will get their money, up to $100,000 per individual per bank and $250,000 for most retirement accounts. The U.S. might not do well at saving across the board, but those that did often had more than the insured limits. The advice being given now is diversify and stay under the limit.

That IndyMac went out of business is shocking but not surprising, despite their $32 billion in assets. They specialized in writing loans with incredibly loose lending requirements, giving loans to borrowers who wouldn't have normally qualified on income or assets. They were a banking slut that contracted a financial disease. The company sold most of the loans it originated, and its strategy seemed sound, but as defaults piled up, IndyMac's finances went to hell in a hand basket. They didn't do anything that hundreds of smaller mortgage lenders didn't, and the same issue also brought down two of America's largest financial institutions. Bear Stearns Cos., sold/rescued in March 2008 by J.P. Morgan Chase & Co., and Countrywide Financial Corp., the one time largest mortgage lender in the nation that was forced to sell itself to Bank of America Corp. at a firesale price.

Fannie Mae and the Other "Mac"
Approximately half of all mortgages in the United States flow through two companies, Fannie Mae and Freddie Mac. Online advertising might be a twenty-plus billion dollar a year business, but these two entities have financed more than five-trillion dollars worth of home loans, and regardless of our feelings about them, they play a critical role in the economy. They are also at the center of much of the recent discussions and turmoil this past week. Whereas it took the Nasdaq a year to shed half its value, both Freddie Mac and Fannie Mae managed to lose half their value in a week, a little scary for firms that play such a large part in underwriting America. Unlike Nasdaq of eight years back, these two companies didn't give up recent gains; instead, they gave up market capitalization like a contest on the Biggest Loser, off 80 percent for the year and touching levels not seen since 1991.

Pressure is mounting on both Fannie and Freddie to raise fresh capital to offset the tumbling values of home loans they hold. As the Wall Street Journal reported, "If Fannie Mae and Freddie Mac were ordinary corporations, the sudden collapse of investor confidence last week would have set them to work on their bankruptcy applications." They aren't "normal." Fannie Mae was created in 1938 as part of Franklin Delano Roosevelt's New Deal because the collapse of the housing market in the wake of the Great Depression discouraged private lenders from investing in home loans. Freddie came about two years after the privatization of Fannie Mae in 1970 to provide a balance to the monopoly of Fannie Mae. Again, as reported by the Journal, "Although they are (now) owned by shareholders, Fannie and Freddie are government sponsored enterprises, or GSEs, chartered by Congress to perform a government mission: providing a national market for mortgages and enhancing the availability of affordable housing. This, together with a brace of special statutory exemptions and the fact that the U.S. government has always bailed out its GSEs, has led the capital markets to believe, correctly, that the U.S. government will never allow Fannie and Freddie to fail."

After the free fall in their stock, the seizure of IndyMac, and the questioning of Wachovia and Washington Mutual about their health, the plan to prevent the failure of the US mortgage backbone was announced by Secretary of the U.S. Treasury Department, Robert Paulson. Unfortunately, according to noted investor and former partner of George Soros, Jim Rogers, the plan is an "unmitigated disaster.'' But, something must be done as the housing market, already in trouble, would be shaken in a way not imaginable if these two firms failed as they are practically the only ones buying mortgages today. Again, says Rogers, "...they should've gone bankrupt with all of the mistakes they've made,'' and "What's going to happen when you Band-Aid and put some Band-Aids on it for another year or two or three? What's going to happen three years from now when the situation's much, much, much worse?'' Unfortunately, more questions than answers, but the Band-Aid will probably keep fears at bay until the next flair-up.

Lessons Learned?
As we said a month ago, until now, it's felt like a sprint. Ultimately, though, we are in a marathon. The real lesson here is not just perspective, patience, or focus, but avoiding the trappings of success. Fannie and Freddie for example never would have thought they would fall on hard times. And, given their special status and the implied backing of the government, they didn't have to hold much capital. Amazingly, the reported combined capital of $81 billion represents roughly just 1.6% of the mortgages they own or guarantee. Given that many banks have seen defaults in the 2% or greater range, Fannie and Freddie have slimmer margins than a startup affiliate network. As Peter Wallison, a senior fellow at the American Enterprise Institute says, this isn't just about two companies that grew out of control; it's a story of how two companies have taken the U.S. economy hostage, and if we think it's a new story, it's not. An article from 2002 for example laments their lack of accountability, transparency, high risk, and the fact that not just shareholders would be hurt but all tax payers. As for a company holding an ecosystem hostage, that sounds a little bit like the situation in the internet advertising world.