The Fed is Going Against The Basic Advice of Every Financial Advisor

The Federal Reserve is years in to and trillions of dollars vested in it's rehabilitation of the economy known as Quantitative Easing. To be sure, the Fed has the best interests of the economy and the wealth of the nation in mind. Unfortunately the tool it has decided to use and reuse is it's unforeseen effects, most notably the "yield grab".

The common mantra of every financial advisor to each of their clients is "diversification, diversification,  and diversification". Just the other day a well-respected and experienced money manager with a large fund was asked his opinion on the stock market and it's recent stellar performance. His take was maintain the long term view and stay diversified. By taking this approach the common investor can avoid the stress and the resulting mistakes short term and medium term traders make.

There is only one problem with this venerable advice: the Fed won't let you do it. Diversify, that is. The Fed doesn't make it illegal to diversify, that wouldn't work. No, through their actions the Fed has orchestrated one of the most massive "squeezes" ever seen. By printing money (QE) and purchasing mortgage backed securities and treasuries and therefore reducing the yield curve, everything from FDIC insured savings accounts to junk bonds (corporate) offer very little in return to investors. As a result, investors pursuit of yield has forced them to allocate monies that would normally be invested more cautiously in to more risky equity assets.

Unfortunately, and perhaps the cruelest twist to this effect are the investors that are most affected. Investors that are nearing retirement or are already retired and would normally allocate more and more towards less risky fixed income investments are left without many options. At a time in their lives that financial advisors would be suggesting they get more exposure to insured bond funds and reduce exposure to equities these investors cannot afford to as there  just isn't any yield. The result is less diversification and more reliance on equities. As long as equity markets are rising this doesn't present a problem. Unfortunately, equity markets don't move in one direction. They also go down and sometimes they go down a lot. This can be very uncomfortable for an investor living on the return of those investments.

Fixed income and their yields are not the only asset class suffering. Recently most commodities are also being affected. As the Feds policies pump up the equity markets unfortunately those policies have not had the desired effect on the economy as a whole. As a result, as the economy has not responded well to the Feds money printing, commodity values are reflecting such and are falling leaving another losing asset class that investors cannot rely on. It may be that equities can "save the day" and suffice as the lone asset class that investors need to rely on. However, this does not change the fact that the Feds actions are responsible for forcing investors away from responsible investing habits and creating the potential for catastrophic results should some black swan event rear its head.

JPMorgan and Risk Taking 101

Now that the dust has settled for the time being, thanks in no small part to Morgan Stanley bungling the Facebook IPO, the reality is that the true extent of the losses that may be attributed to the "hedge" that JPMorgan used is still unknown and incalculable. What is odd is how JPMorgan describes the position. The bank would rather refer to the mistake as a hedge gone bad as opposed to a trade gone bad. Perhaps the bank feels public perception of the gaffe would be less severe if it was construed as a mechanism to protect against a potential loss versus a overly aggressive position taken by the bank to increase profits at the expense of depositors and tax payers. Regardless, what cannot be changed is the impact this will have on the perception of Jamie Dimon as a beacon of omniscient banking knowledge and experience. At the very least, Mr. Dimon should be less vocal and outspoken about suggesting less banking regulation going forward. What are your thoughts? Leave me a note in the comments section. Thank You!

Are Lower Mortgage Rates Really Helping the Economy?

The Fed's intention by implementing it's Operation Twist is to lower long term rates which should lower rates for most homeowners mortgages. The theory goes that as people save money in one area they will spend it in other areas. But is this true? Can the Fed really manipulate homeowners and therefore consumers?

Will Rates Fall Low Enough to Make a Difference?

Typically most homeowners will look for at least a quarter percentage dip from their current rate to even consider refinancing their mortgage. This is more rule of thumb than anything more financially sophisticated. Some homeowners are more focused on rate, others on nominal dollar savings, and others on costs associated with refinancing. Right now most analysts expect Operation Twist to lower long term rates by 20 basis points or 0.20 percent. Based on the refinancing rule of thumb discussed above the Feds actions won't lower rates enough to provoke widespread refinancing by homeowners. If most homeowners that were qualified based on traditional measures such as credit quality and sufficient home equity have already refinanced, and that is a big assumption of course, how many of these folks will be encouraged to go out and do it again, probably having just gone through the process? In an effort to generate more revenues, banks are looking at more ways to charge fees to consumers and some of these are showing up in home loan closing costs. A borrower who refinanced 6 months ago will probably face higher closing costs requiring a bigger savings from refinancing to justify the time and expense involved.


Now that Rates Have Fallen Low Enough, Will Consumers Spend Their Savings?

We have just given the Fed the benefit of the doubt that Operation Twist was successful in lowering rates and that a slew of homeowners have rushed out and refinanced their mortgages. With lower monthly housing payments of around $200 each (I made that up. Most homeowners I've talked to seem to have a love affair with saving at least $200 to even consider refinancing) homeowners are feeling flush with cash and cannot wait to go....(drum roll please)...save it. Sure some folks are going to feel good enough, at least initially, to go out to dinner one more time each month, but how long will that good feeling last? With the latest consumer confidence figures out and not looking very optimistic, how realistic is it to think consumers will be in a spending mood?

Now That the Entire Mortgaged Population has Refinanced, What GDP Growth Can We Expect?

The most optimistic outlook would only contribute a modest bump to GDP, and that's assuming most go out and spend their savings. How do we figure this? Well, let's look at some rough numbers since we cannot be truly accurate. If there are about 75,500,000 residential mortgages on US properties and each of them were refinanced, and each could save $200 a month, and each homeowner went out and spent those extra $200 each month, that would add about 1.2% to our national GDP. For simplicity, let's ignore the velocity of money for now, because I think it is very realistic to assume not that many mortgages can or will be refinanced for various reasons already discussed. So if the actual number were half these numbers, is this a substantial boost to the economy? Maybe so if you're talking about an election year and you're looking for any port in a storm. As important as the contribution to GDP is the improvement to the US labor market, particularly in an election year. Can this modest contribution to GDP from Operation Twist help to bring down unemployment in the US? Perhaps as part of a larger package to stimulate economic growth Operation Twist can be considered a successful endeavor by the Fed, but on its own it will probably not succeed.

Twist and Shout

On Tuesday the FOMC was late in delivering it's much anticipated statement following an extended governors meeting. Apparently the wording of the final statement caused the delay. However, it should be noted that three governors voted against the statement and may have caused some of the delay in finalizing the statements language. The focus of this meeting by the markets was the Boards anticipated details on its operation "Twist", which is goofy terminology for selling short term securities and investing the proceeds in long term securities in an effort to lower long term rates and flatten the yield curve. This mechanism is meant to stimulate economic activity and resuscitate the staggering American economy. The more likely explanation for operation "Twist" is to show the public (the voting public that is) that the Fed is not standing idly by while the economy and the markets flounder. Will this latest effort achieve its goals? Only time will tell. Up to this point more dramatic actions (QE and QE2) by the Fed have not achieved their intentioned goals. It's interesting to note that typically a flat yield curve reflects a struggling economy if not outright recession. Falling long term interest rates (what the Fed is trying to achieve) reflect a market that does not anticipate growth and therefore inflation in the future. The markets could very well get spooked by the profile of the Feds desired yield curve and actually have an adverse reaction to the Feds latest actions.

What's Most Likely to Happen?

We like to anticipate what will happen so that we can look back and see how accurate (or not) we were in our assessments. Here's my take on the likely outcome of the Feds latest moves: Operation "Twist" WILL lower long term rates initially and more qualified creditworthy homeowners will be able to refinance their current mortgages and reduce their monthly obligations, more so than if nothing was done by the Fed. What is difficult to assess or establish is whether this would have occurred anyways as a result of natural market forces (investors fleeing to the safety of Treasuries) as equity markets tumble. What will not happen, unfortunately, is the Feds real desired outcome of inflating the US equity markets once again to create a wealth effect that will result in a trickle down effect that will then spur more business activity and therefore more demand for labor.

Why It Will Not Work

The Fed is trying to fix the wrong problem (slowing economic activity) using the wrong mechanism (lowering interest rates). The real problem the US finds itself with is an over-leveraged and over-burdened society that has over the last 30 or so years lived beyond its means. The Feds approach is to "fix" things so that we can all go back to doing things the way we used to. That is the wrong approach to take and it will not work. The Fed simply cannot fix this problem and it does not have the answer and should not be leaned on further to fix the economy. What the Fed can do for a start is to let the markets know that it should not be counted on for additional stimulus to inflate equity markets to create a wealth effect. Until this is done, market volatility will continue. Once investors understand that the markets must stand on their own, more realistic levels of value can be achieved and more price stability should occur. A possible outcome of this should be fewer companies trying to maintain lofty stock values to appease shareholders. The quick and dirty way to appear profitable is to cut what typically is most companies biggest expense, which happens to be labor.  Until companies reach some kind of cost/revenue equilibrium, hiring will not occur. As one of the Feds dual mandates is to maintain employment, it is in the Feds interest to let companies achieve economic equilibrium. Lower long term interest rates are not the answer to achieving this economic equilibrium.

Market Reacting to Greece Fears or Just Reacting?

From one day to the next the stock market and the bond market seem to move because of concerns in Euroland and specifically Greece. In many cases Europe and Greece seem a very convenient excuse for traders to move in and out of positions on a whim, and the media without any better explanation, are happy to use them to explain moves in the market. The reality is that the markets are sensitive to almost everything that occurs around the world, both financially and politically. To think there is no connection with Europe and Greece would be naive. However, the likely reason for the volatility in the markets is just traders moving in and out of positions trying to lock in profits and not get caught on the wrong side of a trade. Fundamentals do not seem to be relevant or that important to the markets currently. And as markets and trades are increasingly computer model driven, it is advisable for small traders and investors to stay away. Trying to guess which way the wind is blowing in a particular week could be devastating to a portfolio. The sidelines are the best bet in this environment, but if the sidelines are not for you, focus more on the technicals and less on the headlines.

FEDERAL RESERVE BOARD RAISES DISCOUNT RATE

The Federal Reserve raised the discount rate by 0.25 to 0.75. This is the lending rate the Fed uses when it makes emergency over night loans to banks. The market has taken the move in stride, in fact, the market has garnered strength from the move and continues to move higher using the increase as a vote of confidence in the economic recovery.

Early Foreboding: Foreign Holdings of Treasuries Fall

In what could be a negative foreboding for the US governments ability to continue to finance it's budget with Treasury securities, foreign holdings of US Treasuries fell, specifically holdings by China, which fell below that of Japan, leaving China as the second largest holder of US Treasuries. The obvious conundrum for the US Treasury is the threat of higher interest rates to continue to attract demand for it's securities at a time when the US's amount of outstanding debt is at an all time high. In turn, as Treasury's securities yields rise, these higher yields will ultimately be passed on to US consumers in the form of higher mortgage rates, credit card rates, auto loan rates, etc. at a time when the US consumer is continuing to strain from too much debt and must continue to deleverage.

What happens if rates start rising before the US consumer is prepared? Unfortunately, for many homeowners who have adjustable rate mortgages or two-step loans (loans that go from a fixed rate to an adjustable rate) higher rates may translate in to higher mortgage payments additionally limiting consumers discretionary income, meaning fewer car purchases and other purchases that will help sustain the US economy after the inevitable withdrawal of Federal stimulus.

Forcing the US government's hand?
The government has pledged to keep rates at exceptionally low levels for an extended period. This language has been incorporated in to the Feds policy statements for the past year. However, the Fed only controls short term rates, not long term rates. And those short term rates have been cut as low as they can go. Long term rates are moved by the market. As long term rates move higher, the yield curve steepens. While this is good for banks and financial institutions, at some point there must be a correction as depositors demand higher rates for their money, causing the yield curve to flatten.

EU Has Answer for Greece?

On Thursday, February 11, 2010, the U.S. equity markets rallied as investors looked forward to details on a Greek bailout plan. Unfortunately, no details would be forthcoming on Thursday, so the markets decided they would rally in anticipation of details that would outline a lifeline for Greece and presumably other troubled Euro nations that may find themselves in similar straits.

It appears that markets will move on any information or disinformation in the marketplace. It seems that the markets moved based more on the fact that they had sold off and were primed to be bid up by participants. Can anyone explain the recent moves by United Airlines' stock while the rest of the market (and other airlines) seemed mired in a limited trading range? Hard to explain this one. Because of the lack of retail participation in the equity markets (atleast the last 12 months), we can only assume that professional investors are picking particular stocks and bidding them up between eachother hoping for retail participation to then unload on at inflated levels. Sound paranoid? You bet it is. And why not. If you bought the S&P 500 ten years ago and held it until today, you'd be up exactly your dividends received and that's about it. Why take that chance with risk when you could have performed as well or better in a fully-insured bank ceritifcate of deposit, or better yet, AAA-insured municipal bond? Should investors be skeptical? You bet they should.

On the political front, Washington DC remains covered in snow after a historically massive snowfall and government offices remained closed for a fourth day. I think this respite from political haggling over everything from health care reform to job creation plans, is much needed. The amount of cynicism in Washington DC rivals only that of Californian's belief that the state can be saved from it's budget woes. Is there a savior for California? I saw a nice commercial with Meg Whitman this morning. Maybe she has an actual plan. I say give her a shot. Maybe the entire working population of California can go to work for eBay. Just a thought.

Market Takes Big Hit on PIGS and Jobless Claims

On February 4th the equity and commodities markets got crushed after fears of budget issues with PIGS (Portugal, Italy, Greece, and Spain) rattled investors in the Euro zone and continued to cause angst in the US markets. The dollar also weighed on commodities.
It's hard to take these moves seriously when the news of the day drives the market dramatically up and down, with the end of the world one day and an economic rebirth the next. The best thing for investors to do is keep their wits about them and evaluate their long and short term objectives and not get caught up in the capricious market undulations. Over reactions to the swings in the market can indeed ruin a portfolio. If you are in it for the long haul, it's best not to watch the market every day. If you are a short term investor or trader, it makes sense to stay defensive and hold small positions and honor your stops.
The market rally that started in March 2009 is officially over. Several technical levels have been breached. The S&P 500 closed below the technically significant level of 1,073 and closed at 1,063. The Dow fell below 10,000 for the first time in 3 months and closed just above the important psychological benchmark. I think the market will remain volatile and we will see a bounce back that reassures investors only to be followed by further declines.

Market Slides on Obama Bank Plan

On January 21, 2010, President Obama announced plans to regulate proprietary trading for the nations banks. As a result of this shot across the bow, financial stocks and the markets in general declined bringing 2010's stock gains in to the red. The Presidents comments in conjunction with China's decision to limit it's banks lending volume has caused much consternation for the equities and commodities markets. Some market pundits argue that this is the beginning of a long overdue correction the market has been anticipating.
I agree that a market correction is overdue and in the long run healthy for the markets. Before this week, the S&P 500 was up every day in January except one, a sure recipe for a much harder crash. Now, despite better than expected earnings from some industry leading companies, the market seems poised to break down through technical levels and provide the much needed correction. The question is, how long and how low a correction can we expect? And can the nascent recovery handle a declining equities market which up until now has presumably provided a wealth effect for some consumers?
The gains in the stock market have overshot the fundamentals and assumed a "V" shaped recovery, which is not materializing. However, the liquidity provided to the market to recapitalize the banks and reflate assets values is the primary cause of equities prices overshooting fundamentals and therefore approaching another painful correction. It's hard to blame the policy makers for this when the alternative was a failing banking system and imploding economy.

Coakley and Democrats Lose Massachusetts Race

Martha Coakley has lost the Senate race to Scott Brown after the passing of Edward Kennedy in a stunning upset for Democrats and President Obama's campaign to overhaul the health care system. Stock market pundits are calling for a rally on expected political gridlock in Washington D.C.
Scott Brown was expected to win the race by the time the election rolled around and the major indices were all up atleast 1% by the close on Tuesday.
Also Tuesday, IBM announced results after the close and beat expectations but the Street was less than impressed and shares sold off in the after hours giving up all of Tuesdays gains. Pundits figured good results were built in to the stock and the price was no longer cheap, after rallying 60% in 2009.
On Wednesday I anticipate stocks may rally mildly but will not surge as the pundits estimate. In 12 hours from this post, we will find out how the Street interprets the Brown victory.

Obama Inaugurated as 44th President

Barack Obama was officially inaugurated as the 44th president of the United States of America. On a cold blustery day in front of the Capitol Building in Washington D.C., President Obama was sworn in to office before atleast a million attendees.

President Obama's first speech as President was exceptional and left the audience and viewers with a sense of purpose and hope for the future laced with warnings about the amount of hard work required ahead to fix the problems on the global relations front (Iraq and Afghanistan) and the domestic front (the economy and the financial crisis).

I thought the newly elected President's speech was forceful particularly in light of the former President sitting to his immediate left. I did not think there was any ambiguity to Obama's harsh undertones of critical judgement of the prior administration. And justifiably so. I thought Cheney being led away on his wheel chair was very symbolic of "out with the old administration and in with the new".

The road ahead has many challenges but atleast newly elected President Obama brings a sense of courage and hope in addressing and meeting those challenges. I am very confident looking forward with our new President.

OBAMA WINS PRESIDENTIAL ELECTION

In what is possibly the most historic event in most young peoples lives (under 40) the first African-America ever has been elected to the highest office in the land.

I congratulate Barack Obama and Joe Biden on their election victory. John McCain was gracious in defeat and gained my utmost respect with his concession speech. Cheers to John McCain.

Now President-elect Obama can look forward to undoing all the wrong that has been done to this country and the world. Best of luck!

The End of the World as We Know It?

Maybe not that bad, but troubles in the financial markets are starting to cause some grave concerns with government officials. As if Fannie and Freddie weren't enough, over the weekend Merrill Lynch was bought (read: saved) by Bank of America, Lehman Brothers (all 158 years of it's history) chose to declare bankruptcy, and AIG (just the largest insurance company in the country) started pursuing large amounts of capital or it was threatening to go the way of Lehman (AIG's story is still developing).

Talking heads are using terms like "changing landscape of Wall Street" and the "end of Wall Street as we knew it". And they're probably correct. Now that Bear, Merrill and Lehman are effectively nothing more than memories now, and only two large investment banking firms are left standing (Goldman Sachs and Morgan Stanley), the face of Wall Street has indeed changed. There are plenty of things to argue about regarding the current crisis and these failed institutions. It's just a question of where to begin?

Should these firms have been bailed out?

Could this whole mess have been avoided? And who's to blame?

Where do we go from here? How do we avoid the same mistakes?

US Govt Bails Out Fannie and Freddie

Over the weekend, the U.S. Government stepped in and took over the two beleaguered GSEs (government sponsored enterprises) Fannie Mae and Freddie Mac. The move was not unexpected and was almost anticipated, but the rapidity with which the move was made caught some folks off guard. On Friday, September 5th, Fannie Mae stock was actually trading up before the close, and had been climbing over the last couple of weeks. To think that the folks buying the stock (or even short-covering) would make this decision in the face of a takeover makes little or no sense. Therefore, it seems this move caught atleast some folks unawares.

The Street had been clamoring for this move for the past six months, and maybe twelve, and they've finally been satisfied. Fannie's stock was down to $0.70 on the monday after the announcement and Freddie was similarly down, in anticipation of common shareholders being almost if not entirely wiped out. Now that the Street has it's desire, does this make sense and will it help the housing and mortgage markets improve? The idea is that with the government's explicit guarantee, debt issued by the GSEs and their mortgage-backed securities, should carry less perceived risk and therefore have lower yields. Sure enough, on the mortgage rate side, rates have come down, in some cases substantially. However, is this a trend or a momentary blip on the radar? Several analysts are indicating that the housing market still has more downside and until inventory subsides and prices stabilize, the bailout of the two GSEs will not have significant material impact. I say that this is the beginning of the capitulation and the market had to go through this period before any kind of recovery could occur.

Maybe of more significance is the status of the banking system and the health of those institutions that the economy will ultimately look to as credit facilities. The toxin that exists in the market place must be removed for the economy to make any kind of recovery. As long as concern and uncertainty about the health of the debt and assets of the two GSEs continued, the credit market was not going to recover but was going to continue to flounder, as too many credit market participants were holding their securities. Now that the government has stepped in, these securities should strengthen and with them the health of most of these credit providing entities.

Fed Leaves Benchmark Rate Unchanged

The Fed left it's target fed funds rate at 2.0%, as widely expected. The stock market cheered the non-change and the Dow rallied over 200 points. The url below links to the Board of Governor's website and the FOMC statement:

http://www.federalreserve.gov/newsevents/press/monetary/20080805a.htm

Bush Signs Housing Bill

President Bush signed the Housing bill at 7 AM ET Wednesday morning to little if no fanfare.
Treasury Secretary Henry Paulson and a couple of others were on hand to oversee the signing.

One can only surmise distaste of the bill on the part of the Republicans by the perfunctory manner in which such seminal legislation was passed by the White House. Not to mention the importance the legislation will play in helping the U.S. housing market, as well as the economy as a whole, in its attempt at recovery.

Leading up to the signing of the bill Republicans were objecting to the possibility of using taxpayer money to bail out the two GSEs (government sponsored enterprises) FNMA and Freddie Mac. $25 billion was the estimated amount of taxpayer money that may be required to bail out the two mortgage finance companies. The objection is heard and noted, however, why would the use of taxpayer funds be so objectionable if it is taxpayers as a whole that will most certainly benefit by a healthy mortgage secondary market as provided by the two GSEs? It is also understood that not all taxpayers are homeowners and therefore should not have to contribute their hard earned tax dollars to the bail out. True enough. However, most renters do aspire to be homeowners one day, and if they hope to achieve that goal, it will be reliant upon the existence of the two mortgage giants to make that happen. In essence, all taxpayers have a vested interest in the existence of the GSEs and if the tab were to be $25 billion or some other such amount, it doesn't sound like a price too high to pay.

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Think of NMZ Financial & Markenomics for residential mortgage and home loan needs for Lamorinda, Lafayette, Moraga, Orinda, Contra Costa County and all Bay Area and Califorina real estate.

Lawmakers Agree on Bill To Bail Out FNMA & Freddie Mac

On Wednesday, July 23, the House of Representatives is set to approve a bill aimed at alleviating the current housing crisis as well as rescuing FNMA & Freddie Mac, the two government sponsored enterprises (GSEs). Part of the bill will authorize Treasury Secretary Henry Paulson to bail out the two GSEs and place few restrictions on the two large mortgage finance providers.

Please click on the links below to go to the homepages of both FNMA and Freddie Mac.

http://www.fanniemae.com/index.jhtml

http://www.freddiemac.com/

A previous obstacle to the success of the bill was the veto threat by the Bush administration due to the bills provision to provide $3.9 billion to communities for the purchase of foreclosed properties.

The bill appears to leave the two GSEs basically intact as autonomous organizations with few additional limitations which would have possibly harmed common shareholders. The bill does not impose any restrictions on the GSEs abilities to continue to pay dividends to shareholders. Also important is the point that the Treasury will not receive preferential treatment over other shareholders if it decides to inject capital into the GSEs through the purchase of preferred shares of the GSEs.

The bill does add provisions for a stronger regulator of the two GSEs as well as additional oversight. The Fed has already begun reviewing the books of the GSEs to verify their capital position and liquidity. One goal of the bill is to enhance the market's confidence in the GSEs. FNMA and Freddie Mac common stock is down 66% and 72% this year, respectively. The importance of the companies to the American financial system and economy as a whole cannot be overstated. With the collapse of the secondary market for morgages and Wall Street's inability and unwillingness to participate in its recovery, FNMA and Freddie Mac remain two of the few options for creating a market for mortgages, along with lesser known GNMA and FHA.

One pleasing aspect of the bill to both borrowers and lenders in high cost housing markets, such as the Bay Area, is the higher cap on loan amounts that will result. The new conforming loan limit would become $625,000, or the median home price plus 15%, for both FNMA and Freddie Mac.

SEC's Unusual & Interesting Move On Short-Selling

On Tuesday, July 15th, the SEC made the unprecedented move of limiting short selling in certain stocks in the financial sector. Viewing the financial sector as already weakened, the SEC made the radical move to prevent further weakness to many beleaguered companies in the sector, most notably, FNMA and FHMLC, amongst others. The past week has seen massive selling in the stocks of the two GSEs (government sponsored enterprises) and brokerage firm Lehman Brothers. In an ironic twist, it should be noted that the two GSEs stock declines picked up intensity on a Lehman Brothers analyst's research report, that received much media attention over the July 4th weekend, regarding the two companies weak capital positions exacerbated by a FASB accounting rule change (which, again ironically, the analyst conceded would not even apply to the two GSEs).

Short selling is the act of selling a stock that is not owned but borrowed and then sold. The action the SEC is limiting is the act of "naked" short selling, that is, selling stock that is not owned while no attempt is made to borrower the stock. In short selling, money is made by selling at a higher price and buying the stock back at a lower price, the difference being the profit. The SEC is limiting naked short selling for the next 30 days, starting Monday, July 21st.

Because FNMA and FHMLC play such a significant role in the housing industry and are critical in the sector's recovery, the Federal government has been active in trying to shore up confidence in the two GSEs. Their declining stock values and eroding investor confidence make it harder for each to raise capital, and this week Moody's Ratings Agency downgraded the preferred stock and bank rating of each. One trader referred to the stock declines as "thermonuclear". The following url links to a Fortune magazine article on Moody's downgrade.

http://dailybriefing.blogs.fortune.cnn.com/2008/07/15/moodys-casts-jaundiced-eye-on-fannie-freddie/?source=yahoo_quote

Although the SEC's move seems dramatic and radical, it is believed that such a move will have little impact on curbing the short selling in the market place and will do little more than make it mildly more expensive for short sellers to operate. Many argue that short sellers are a necessary part of a healthy market as the action alerts the market to overpriced securities and naturally deflates inflating bubbles.

I think the US Government has stood by long enough and cannot afford to let the market dictate the fate of the two GSEs. I have never believed in a purely capitalistic model, and the Governments role, however limited, must exist as a safeguard in unusual circumstances, and these circumstances continue to become more and more unusual.

FNMA & Freddie Mac - Could They Really Fail?

On July 7th, FNMA (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) stock declined over 15% each to 14 year lows, primarily based on capitalization concerns. A Lehman Brother analyst surmised that an accounting rule change (FASB) would require the two GSEs (Government Sponsored Enterprises) raise as much as $75 billion in additional capital to meet the new capital requirements.

As it turned out, that same analyst conceded that the possible rule change would not apply to either GSE and that they would be exempt from having to raise the additional capital to meet the requirement. Unfortunately for investors of both GSEs and for the GSEs themselves, the damage had been done. On Wednesday, July 9th, FNMA issued $3 billion in two-year notes and paid the highest spread to date on those notes. The yield spread to comparable U.S. treasury securities was 74 basis points (0.74%). By way of comparison, last month FNMA issued $4 billion in two-year notes and the spread to comparable U.S. treasury securities was 65 basis points.

What does this mean? Basically, it is costing FNMA more to raise capital today compared to yesterday. This raises their cost of capital and to maintain their profit margin, it means higher rates for investors and therefore higher rates for borrowers who want to purchase a new home or refinance their current home.

If both GSEs have implied government backing, that presumably means the U.S. Government would not let them fail, why is there so much fear on the "Street" about their well-being? It could be that the "Street" does not believe the Government would come through and bail either out in the unlikely event that they fail. Or, it could be that the investing community views a worst-case scenario equating to a Government bail-out with no remaining equity for investors. I am not sure what, if anything, will come to pass, however, the credit markets are giving their own interpretation of FNMA's well-being and it's not very positive.