The Perfect (Financial) Storm

Perfect Storm: a critical or disastrous situation created by a powerful concurrence of factors. [Mirriam-Webster's Online Dictionary]

Storm Clouds by CoreBurn / © Some rights reserved.
Licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives license

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Many people had given dire warnings about the serious problems the economy would be facing. Some even knew it would extend far beyond the United States. But few predicted the severity, scope and timing simultaneously, because of the complex commingling of the events. With hindsight, things become that much clearer.

Three factors--all of which were major contributions--were the reason why the world economy is now facing a global economic downturn of this level of severity. Any of the three occurring on their own would not have caused as much damage as we will now see in the coming months. All three are of course interconnected, but few specialists knew enough about one, let alone three to accurately predict the damage that this storm would cause.

The Road: Questionable Lending Practices
There was of course, Fannie, Freddie and the irresponsible lending practices promoted by government coalitions with free markets. This built a road that led to the edge of a cliff had been construction for decades only to be completed by about 2005. Warren Buffet who is often lauded as the World's best value-oriented investor, divested his entire position in both Fannie and Freddie all the way back in 2000. Buffet said he felt "uncomfortable with certain aspects of the business." It's also clear that many Washington insiders knew a problem was brewing here. In 2006, several Republicans (including John McCain) sent a letter to the majority leader which warned that "if regulatory reform for housing-finance government sponsored enterprises (GSEs) is not enacted this year, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole." The list doesn't end there, many others knew about fundamental flaws and an inappropriate risk profile for these quasi-government enterprises.

The Vehicle: Energy Price Shocks
Then there was the lack of a stable and sufficient energy supply (particularly oil), which served as the vehicle that had also been assembled over the course of several decades. Peter Tertzakian had some very impressive and accurate foresight with regards to oil 'breaking' the economy. In his 2005 book, he says that the world economy would stop, "'firing on all cylinders' in 2007," and in 2008, "a confluence of events [would force] the public and our nations' leaders to finally realize how vulnerable [the economy] had become [to oil prices]." He goes on to predict a plunge in SUV sales and automaker mergers, acquisitions and consolidations we are now seeing (his forecast calls for Toyota partnering with or buying GM). What he didn't foresee is how high gas prices would catalyze a collapse in suburban home values. With this, the assumption which was held by so many now troubled financial institutions--that home prices always go up--also failed.

The Fuel: Monetary Policy
Lastly, there was the fuel: credit money. Because markets are based on a fiat currency (based on a perceived value) rather than the gold standard (based on intrinsic value), the system is subject to bubbles, sometimes resulting very large corrections (the gold standard has its own drawbacks of course, which is why the two standards have been swapped many times throughout history).

Instead of going into too much into detail about how the world moved from the gold standard to a system of credit, I'll give a brief synopsis here (google it if you want to know more). Following the World Wars, the United States was in a very strong economic position (much like China today), as it was spared widespread damage on its own shores while Europe's infrastructure had been devastated. The country was extremely productive relative to other countries and awash in natural resources. Because they were in a position to lend money for the rebuilding of Europe, they formed the Bretton Woods Agreements (1944/1945). Essentially, the U.S. pledged to maintain a stable dollar by pegging its currency to gold, and all other currencies were in turn pegged to the United States Dollar. Several decades later, when the U.S. started to become a borrower rather than a lender as well as overextending itself with several wars, the hybrid gold standard to become incredibly unstable. It was officially abolished in 1971 and all major currencies were subsequently unpegged from the USD by 1976. No politicians in any of the major economic power had the political leverage to go back to the gold standard because fiat money allows for inflation and inflation makes the economy look good. Instead, national banks pledged to control inflation using imperfect price inflationary indicators, such as CPI and later core inflation.

It's not hard to see from the chart that soon after the gold standard was abandoned, the bubble era had begun. Deflation is considered political suicide and therefore the market corrections are always artificially stopped by government (meaning the problems simply build upon themselves). Former 2008 Republican presidential candidate Congressman Ron Paul can offer more on this subject, but the point is it hasn't worked.



It was not oil that was in a bubble at $147; it was the entire economy that was overvalued (homes, cars, equities, etc.). It was not price manipulators, speculators pushing oil prices upward but merely investors moving money from U.S. dollars into commodities to hedge against global inflation. This is why neither gas prices nor equities rooted in these commodities increased by nearly the same amount. Ironically, we now call this a "credit crisis".


In The End: A Terrible Concoction
As I've said, any one on its own, the flawed road, the vehicle or the fuel, doesn't really present instantaneous systemic danger. Had gas prices stayed low, consumer sentiment may have stayed high and home prices may not have plunged with Americans reconsidering the value of homes situated in very distant suburbs. Had monetary policy been better managed, oil prices would have increased more linearly rather than exponential volatility shocking markets (unlike the oil shocks of the 1970's, 2008 had no major supply squeeze). All three would still have presented a very serious threat individually of course, but the "perfect storm" as Bernanke puts it, is why the economy has weakened far more than many of the partitionary experts had predicted. I would caution that conditions are likely to continue to get worse even if global financial markets can be stabilized. Political instability has become one of the spillover effects and history has shown it is very difficult to maintain peace in the case of poor countries (or bankrupt ones). And yet I remain optimistic for the future, because after the storm, nature always rights itself. Always.

America's Fundamentals

A Fundamental Subprimer:

1938 - Fannie Mae was created under President Roosevelt as a government entity to provide liquidity to the housing market in the wake of the Great Depression.

1968 - Fannie Mae was pseudo-privatized by President Johnson to remove it from the federal budget. To make this privatization feasible, the company was made exempt from taxation and oversight. To ensure competitive market, Freddie Mac was created in 1970 to perform essentially the same role. Critics say they had no incentive to pay down debt because (1) they were exempt from reporting financial difficulties to the public, (2) they were backed by government as GSE's, and (3) house prices always go up. The effects of President Johnson's overall policy were swift and disastrous (link).

1970 - President Nixon continued tradition by signing the Emergency Bill on Housing, a bill designed to inject "as much as $10 billion a year into the sagging home construction industry." White house construction quotas were still not being met, so interest rates continued to be artificially subsidized. (St. Petersburg Times - July 25, 1970)

2002 - President Bush releases the Home Ownership Policy Book.

The stated mandates of this policy include

• home ownership targets, with a focus on minority home-ownership,
• a $440 billion increase in the financial commitment made by Fannie Mae and Freddie Mac to fund mortgages,
• incentives for other mortgage lenders and
• tax credits and down-payment assistance for new and prospective homeowners

2005 to 2008 - The growing American housing bubble bursts. Financial markets around the globe suffer as a result, especially in late 2007 and the first three quarters of 2008. Fannie Mae and Freddie Mac are put under conservatorship in September, 2008.

September 19, 2008 - In response to market turmoil, Treasury Secretary Henry Paulson announces a plan to buy the toxic assets that were plaguing markets. Critics say it emulates the tradition of creative accounting--moving garbage around in the hopes that it won't start to stink until it becomes somebody else's problem. They say Henry Paulson has just named himself CEO of a new enterprise called Hermie Max. Supporters say they have finally taken the first step in accepting responsibility for these problems.

Obviously, last week's developments in the mortgage crisis have been developing for some time. But it is by no means the only problem the U.S. Economy is facing. In fact, many of the problems have been exacerbated by others which are not mutually independent from the credit crisis.

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John McCain has refined his position that the U.S. economy is fundamentally strong to saying that American workers are the fundamental strength of the economy. Many take issue with both claims. The following is a disquisition as to why.


The Myth of The Hardworking American
As a generalization, the hardest working Americans are actually the landed immigrants. They believe in working hard to obtain 'The American Dream'. Although they are often unable to reach this dream, because of either lack of education or lack of credential recognition, they continue to work hard to ensure their children can live out their dreams. Unfortunately though, n^th generation immigrants (children of landed immigrants and their children) often lose this value of hard work. They tend to feel they are entitled to the American Dream rather than believing it is something they have to work for. They believe the living in America is a birthright rather than a privilege. In a lot of ways, they are technically correct--but that doesn't help labour productivity.

How hard Americans work in absolute terms is not really all that important with respect to the fundamental economy. What really matters is how hard the American citizen works relative to citizens other countries around the world. There is no question that labour unions have done very great things for the working class. However, in well-established societies, unions have basically become an extension of government and their value at present is now rather questionable. In American society today, government already mandates minimum wages as well as reasonable and safe labour conditions. The only purpose left for unions is to squeeze every bit of corporate profits out of the corporation for more benefits and higher pay. Competitive compensation is good, but union practices now make western business uncompetitive in increasingly globalized markets. They have actually caused job loss rather than increased employment. Meanwhile, developing nations were able to produce goods and services without the excessive labour costs exasperated by entitlements and labour unions. There was a very lengthy period of time when this labour cost discrepancy did not matter much for the western world. That's because the west held something more valuable than work ethic: knowledge. The concentration of literacy, education and knowledge in the western world meant that while Dollar Store items were 'Made In Taiwan', expensive technological items like cars and computers were still 'Made In America'. With globalization, the Internet, and other technologies, knowledge is more widely accessible than ever before. Computer science jobs are now being outsourced to India. Japan has taken over the automobile manufacturing industry. In China, the automobile industry is rapidly gaining ground although it is currently still in the 'pathetic' phase at this point. Critics who think they will never be able to make cars suitable for the western world should note that the same thing was said of Japanese automobiles when they first entered the industry. Relative to the American worker, productivity of the developing nation labourer is closing in fast. This is part of the reason why U.S. GDP growth has been declining over the years, while it has been increasing rapidly in developing nations like China and India.


History Does Not Side With US
Many advisers are saying now is the time to make long-term investments in the U.S. economy because markets are undervalued. This is likely true, and markets are indeed likely to be higher in 12 months than they are today. These advisers are saying to look at history as proof that the markets will recover; that markets have always recovered from downturns in the long run. This idea that history is a key to the present is very important--but they are using a panoramic lens instead of taking the 360 degree view. The panoramic lens goes back to the start of the twentieth century; the 360 degree view goes back to the first dominant human civilizations. Dominant superpowers have always overextended themselves to the point that their decline of power becomes an inevitable conclusion. This doesn't necessarily mean the American Empire^* will go the way of the Roman or Ottoman Empires; but it may go the way of the diffused and diluted British Empire. Some historians think this happens because the intrinsic rigid nature of empires leaves them incapable of adapting to change.

*Many Americans are reluctant to call the America an empire, and prefer the term 'superpower'. I suspect this is because of stigma surrounding the fact that no empire in history has ever maintained its hegemony status for more than several centuries. Ultimately though, it will be up to historians to decide on an appropriate title for America's global influence.

The Swinging Pendulum
Turning the focus back to the economy at present, most analysts estimate there is still another 6-18 months before the fundamentals of the United States housing market hit bottom. The reason, they say, is an excess inventory of homes and historically low federal lending rates poised to rise in the coming months when the economic outlook improves. Confidence in U.S. markets has been shattered and it will take some time to repair. Money is on the sidelines and everyone is blaming it on the regulators, greed, and white-collar criminals. By 'everyone', I include those who would normally call themselves libertarians and 'ultra-free-market-capitalists'. They concede that Freddie Mac, Fannie Mae and AIG were too big to fail and in need of a government bailout. They will give very serious consideration to Paulson's plan for two reasons:

1. By not moving toxic assets to the taxpayer balance sheet, it could cause a depression. All but the most idealist free-marketeers will accept government intervention if this scenario proves realistic.


2. The credit rating of the U.S. is being eroded. If the government doesn't bail out China and the other creditors that hold the bad debt, then the foreign creditors will stop lending the U.S. money. It would be like trying to refinance a mortgage after declaring bankruptcy--creditors don't lend to clients who don't repay prior debts.

This is a sign that the ideological pendulum is swinging from right to left, and it is now poised to swing too far to the left. Regulation is a necessary part of markets; but only to provide stability and sustainability in an otherwise chaotic 'free-market'.

Under-regulated markets lead to volatility and unpredictability, while over-regulated markets lead to predictability and stagnation. Growth is good, and so is predictability; it's just a matter of finding the desired balance of the two. The swinging pendulum should be stopped somewhere closer to the center rather than the extremes where it was, and where it is now headed. When the Republican presidential nominee says "the regulators were asleep" and wants to dismiss the SEC commissioner for not regulating markets more, this is rather disturbing for the growth side of the equation.


Debt and Deficits
In defence of George W. Bush--the 9/11 hero that has now fallen out of favour with the American public--his policies are now, like those of most presidents at the end of their terms--more responsible since he doesn't have to worry as much about political backlash. He has threatened or tried to veto virtually all of the fiscally irresponsible bills put forth by a democratically-controlled congress (mostly to no avail). None of the recent bailouts were part of the budget.

Bail Out Recipient	Guaranteed (Public) Debt
Bear Sterns	$30 billion
Freddie, Fannie	$200 billion1
AIG	$85 billion2
'Toxic' Mortgage Nationalization	$700 billion
Big 3 (GM, Ford, Chrysler)	$25 billion3
Total	$1.04 trillion

Notes:

1. Freddie Mac and Fannie Mae could cost taxpayers much more or less, no one really knows yet as this depends on how many more defaults there are.
2. AIG was made to sound like a great deal for taxpayers. The balance sheets of AIG aren't public but there is an unlikely scenario that taxpayers could profit and actually get a good deal. Note that free market enterprises would not capitalize on this potential 'bargain' given the high degree of risk. $27 billion of the 'loan' was reportedly used within a day of the takeover.
3. The big 3 deal is currently being lobbied to U.S. congress. GM is most desperately in need of these funds and some think the figure could be as much as $50 billion.

The U.S. Government Accountability Office states in a 2007 fiscal report that "The government is on an unsustainable fiscal path." It is their job to be alarmist, as this department is meant to hold congress accountable. But even if the debt projections are reduced by an order of magnitude, the picture still doesn't look pretty. This is on top of government deficits that are expected to be US $500 billion (excluding bailouts) for 2008 and only slightly less in 2009.
Neither presidential candidate has a realistic policy platform. Both tax increases and spending cuts are required just to stop the deficit, let alone reduce the $10 trillion federal debt. This figure excludes health care and social security entitlements that are expected to increase in the coming years.

In Canada the health care entitlements are an even bigger problem because of a public health care system. The baby boomers will begin reaching the standard retirement age of 65 in 2011. Health care costs will continue to rise as they have been in recent years and perhaps this rise will become exponential with the aging population blip. At some point in the very near future, Canadians will need to decide between privatizing health care and raising taxes. As the fiscal surplus is gone, there is simply no alternative; but at least in Canada the problem is not compounded by an increasing trade deficit as it is in the United States.


GDP Against Black Gold
America is addicted to oil. Furthermore, it's domestic supply continues to decline meaning it needs to export an increasing amount of wealth to feed it's addiction (see 500 billion dollar problem). As this happens, the U.S. GDP begins to work like the mirror image of oil prices. There aren't too many people left that believe the price of crude oil will go back to $40 a barrel. Given the current level of energy dependence, a sustained price of $40/bbl or less is the only likely way for the American GDP to grow at the same average annualized percentage this century that it has over the last century. This doesn't mean I think the economy can't still grow, but the higher the oil price, the more stagnant it will become. And right now at least, oil prices and the economy are in lock-step--as the economic outlook of the largest oil consumer appears strong, oil prices rise; when economic outlook is weak, prices fall. I can't see how the United States economy can be considered fundamentally strong with oil priced over $100 for each barrel.

It is for this reason of course, that energy independence (or more accurately reduced foreign oil dependence) is now such a hot topic. From this perspective, offshore drilling will help. Though as parties debate how much it will help, oil from this source won't hit markets for at least another ten years. Contrary to popular belief, there is no technological fix to America's energy dependence problem. Any realistic political fix to this problem would need to focus on facilitating revolutionary social change. Most of this required change relates to an incredibly powerful and convenient device called the automobile. There are 250 million registered passenger vehicles in the U.S., more than 8 for every 10 people. The transportation industry consumes half of America's oil, yet no feasible fuel exists to replace gasoline as oil prices rise. The much-hyped alternatives have some potential, but none will result in a seamless transition from oil.

Natural gas
If a T. Boone Pickens-type plan were implemented, NYMEX natural gas prices on the continent would double to approach or exceed prices in Europe. Driving range between refuelling of natural gas-powered vehicles is considerably reduced. While the U.S. has more recoverable reserves of natural gas, they are not that much more, and it would also turn Russia into the new Saudi Arabia.

Ethanol
Brazil's sugarcane-based biofuel model can't be scaled up to meet the transportation requirements of the United States, especially using corn-based ethanol. This fact only became apparent to some legislators when corn and grain prices began to skyrocket to unprecedented levels due to artificial biofuel subsidies.

Hydrogen
This fuel is not an abundant natural resource as it does not exist in its elemental form anywhere on Earth. Currently, most industrial-use hydrogen is generated from steam reforming of natural gas (CH₄ + 2H₂O → CO₂ + 4H₂). Hydrogen can also be split from water using electricity but the process is thermodynamically inefficient--it requires considerably more energy input than a fuel cell will ultimately output. This is why hydrogen fuel cell development has been slow.

Conservation and Fuel Efficiency
Gains here are limited, and the more significant gains come at a price--automobiles that are more expensive and unaffordable. First-generation hybrids (those that don't plug in), are a good example of this.

Electricity
The electric car in its current form can't replace the automobile. They simply don't have the speed or range to meet the current social requisites of America. Batteries just aren't amenable to energy storage the way liquid fuels are. No one had to kill the electric car in the conspirator sense some have suggested. The Chevy Volt is a plug-in hybrid that will to come close to meeting social requirements with an optimistic 2010 production date, but at an estimated cost of $30-40 thousand apiece. GM's Vice Chairman Robert Lutz says that hybrids will never be as cheap as gas-powered vehicles for one simple reason: they require two power-trains instead of one. Instead of trying to meet the social requisites, the auto industry should focus their efforts on creating and marketing electric cars as 'urban utility vehicles' rather than as standard cars.

Given that technology will not provide a seamless transition from oil to other fuels in the transportation industry, Americans will be required to undertake social change. In terms of social lifestyles, what energy independence means is not that air travel, trucks and gasoline-powered cars will disappear completely. However, it does mean that the "soccer mom" who drives three kids to extra-curricular activities in different corners of the city in an H3 Hummer will cease to exist. She will find different activities closer to home without compromising the developmental opportunities of her children. Many people, including policymakers, find this new reduced dependency on the automobile very difficult to visualize because it requires a change in the way we think about transportation. This is why it will likely take 40-50 years before any significant degree of U.S. energy independence is reached, perhaps a decade or two less with political facilitation. And yet, the wheels for this have already been set in motion with the collapse in the sales of gas guzzlers and material reductions in air travel (the gas guzzlers of the skies). High gas prices also served as a catalyst in the collapsed assumption that 'house prices always go up', particularly in distant suburbs requiring excessive commute times. In time, the white picket fence will fall out of the American Dream. Unless the world can continue to produce oil at well over a thousand barrels a second, these changes will continue. Unfortunately for the United States, it continues to lose its grip on oil production, which means the change must be financed from within, and this will hurt GDP and growth as a result.


In Brief
As the western countries continue to lose their monopoly on knowledge, the higher work ethic will allow developing nations to continue to steal market share in terms of productivity for goods and services. As America's domestic supply of natural resources continue to decline, and the overpopulated world continues to consume them at an unsustainable rate. An incredible amount of energy will need to go into a structural change in the American way of life. As this happens, the U.S. will continue to lose its grip on control of strategic resources in countries like Venezuela, Iraq and Nigeria. Even domestically, resistance exists to the exploitation of coal and offshore oil reserves because of concerns about the environment. All of this means America's public and private debt is likely to continue increasing to the point where America will not own itself anymore, its foreign creditors will. Government will become incapable of acting on behalf of its citizens as it will become forced to appease its creditors. Useful work will go towards change, and repaying debt, and it is this that will circumvent growth. This is why the fundamentals of the U.S. economy are not all that good.

Fed buys AIG (courtesy: the American Taxpayer)

I was watching the news today. A headline topic was the proven link between elevated levels of Biphenol A (BPA) in the urine of the adults studied, and an elevated risk of heart disease and type-2 diabetes (full story). An expert on the show noted that the link was not a chemical one and the exact source of BPA in those tested was not determined by the study. It basically proves that we should avoid ingesting BPA (which we already knew). He recommended consumers minimize drinking from polycarbonate bottles and eating from PC-lined food cans. PC is the very hard plastic used in Naglene bottles. As a rule of thumb, if it isn't hard, it probably isn't PC (look for the number 7 or the label 'PC' in the recycling triangle).

Now for the funny part:
As he said this, images of margarine containers, disposable plastic water bottles and other soft plastic food containers were shown. None of the containers shown were BPA-bearing plastics. In plastics, BPA is only used to manufacture polycarbonate (PC) and as an antioxidant in polyvinylchloride (PVC). The products that were shown are made from polyethylene terephthalate, low/high-density polyethylene, polypropylene and polystyrene (PETE, LDPE, HDPE, PP and PS respectively). Other than PVC, which is not generally used in food/drink items, and PC, none of the other plastics are manufactured using BPA!

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In other news..


[Image courtesy of Clarke]


In exchange for up to $85 million in federal loans, the U.S. government will receive a 79.9 percent equity stake in the company.

According to the press release,

"The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance."

Instead of a disorderly failure, this announcement ensures and orderly failure as the company's assets are slowly liquidated until the loan is repaid. Extremely large free market equities have now received full or partial bailouts from the U.S. Treasury (Freddie Mac and Fannie Mae's saviour), The U.S. Federal Reserve (AIG's saviour), and soon U.S. Congress (General Motors' saviour).

To be precise, Freddie and Fannie were not explicitly free market enterprises. Instead, they were implicitly guaranteed companies otherwise known as GSE's (Government Sponsored Enterprises). This was their fundamental flaw. Investors said they were taught in 'investing school' (whatever that is) that theoretically speaking, the entities had the risk of treasuries but the reward of equities. If that sounds too good to be true, that's because it is and always was. While others share the blame, this structural flaw took the lead in granting so many irresponsible sub-prime loans and now results in a cascading effect we are seeing in financial markets around the world.

All this is meant as a primer for my next topic: The Swinging Pendulum--and while change is good, the swinging pendulum is decidedly not a good thing.

Some News and Anecdotes

A Thousand Barrels A Second

"Beginning [in 2006], and over the course of the next 5 to 10 years, increasingly volatile energy prices are going to affect how you live and what you drive, not to mention the economy, the environment, and the complexity of the geopolitical chess match being played out for the world's precious energy resources... we are in the midst of volatility, right on the cusp of a break point that will change the way governments, corporations, and individuals exploit and consume primary energy resources, especially crude oil."

This an excerpt from Peter Tertzakian's book A Thousand Barrels A Second. I strongly recommend this book as you only need to get through the first page to see that the former oil industry "foot soldier" and energy analyst knows what he's talking about.

Anecdote: The New York Times followed up on my news tip with Jad Mouawad's lead business story, As Oil Giants Lose Influence, Supply Drops. I sent in the tip following my post "Big Oil: 2nd Quarter In Brief".

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The Olympic Spirit

Usain Bolt raised eyebrows with his come-from-nowhere gander into the title of "world's fastest man". Three months ago, he raced in his first adult international competitive 100m event. The morning of the Olympics he woke up at 11, ate some chicken nuggets, watched TV, ate lunch, more chicken nuggets, then jogged his way into a new world record and gold medal in the 100m. He could have run faster were it not for his pre-finish celebration and an untied shoelace. This may seem suspicious, but even if he had used performance enhancers a good pharmacist knows how to circumvent drug testing; we may never know whether or not he really did wake up one day realizing he's the worlds fastest person. If he ran clean, it would be nothing short of impressive. Or maybe he wanted to run clean but someone slipped something in his Chicken McNuggets. Either way, the Olympic spirit and excellence more than offsets the less desirable sides of the games. 'Communist' China has thus far hosted the games without anywhere near the level of controversy many of the alarmists and human rights extremists had predicted. Canada topped its Athens podium count with 13 medals.

Anecdote: Simon Whitfield made an impressive come-from-behind sprint in triathlon, nearly clinching gold but finishing with silver. I could feel his pain in the closing kilometers of the run. "It hurt, it really hurt..." said Whitfield. But with 300m to go and 40m behind the leading pack of three, he threw away his cap, summoned some energy from deep within, and commenced his sprint to the podium. He even took the lead before Germany's Jan Frodeno stormed back to rain on the party, leaving Whitfield with the silver.

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Freddie and Fannie Fall Off The Tricycle

Mortgage guarantor Freddie Mac had mixed success with a high-yield debt sale today. Freddie Mac was able to raise over $3 billion in capital. Shares fell another 6% in addition to yesterday's 25% plunge. The likelihood that the mortgage GSE's will require explicit taxpayer backing is a bit of a psychological self-fulfilling prophecy--as investors are told by analysts not to invest in these companies, it makes it very difficult for them to raise capital. As a result, they must do so by offering a very high yield incentive (as was the case in today's sale). The premium will keep them afloat for longer, but it also hurts longer term profitability, which is why equity shareholders continued their sell off. Inflation data from the past week did not help, as it raises speculation that the Fed may need to raise rates sooner rather than later--a move that would likely force Freddie and Fannie to seek public funding if a rate increase were factored in this year.

Anecdote: Last week, I tried to warn a handful of naive investors on the Google Finance discussion board who thought they were getting a bargain on the shares of Fannie Mae (NYSE:FNM). I pleaded with them to cut their losses and move on. Unfortunately they thought I was a hedge fund manager trying to use psychology to maliciously drive down prices. In retrospect, I should have tried to explain that I did not hold any short positions (my investment knowledge is not advanced enough to take short positions). I have no financial stake in Fannie or Freddie whatsoever--I was simply trying to advise them to donate their money elsewhere. Instead the poor souls lost 30% already since then.

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photo credits:
Oil Barrel byblizzy73
Birds Nest by Theo W L Jones
Tricycle by iMorpheus