Remember that scene in Frank Capra’s “It’s a Wonderful Life” when George Bailey (played by the earnest James Stewart) is trying to save his father’s “cheap, penny-ante Building and Loan”? As rumors swirl around the bank’s potential demise, the depositors line up and demand their money---a classic bank run. Given the stories of the past week, some are wondering if we are experiencing a little truth that is stranger than fiction.
Last week, Pasadena, CA-based IndyMac Bancorp was seized by federal regulators, in the third largest banking failure in US history. During the height of the housing boom, IndyMac was a prolific mortgage specialist and became one of the largest savings and loans in the country. The FDIC took over and reopened the doors for business on Monday, sparking concerns among depositors of similar savings and loans throughout the country. As experts attempted to identify “the next IndyMac,” investors and depositors became nervous about the viability of various regional banks.
National City Corp, based in Cleveland, OH, was forced to issue a statement it was “experiencing no unusual depositor or creditor activity.” That may be so, but investors didn’t buy it and the stock plummeted by 15%. Similarly, Washington Mutual said that it “significantly exceeds all regulatory ‘well-capitalized’ minimums for depository institutions.” Shares fell by over a third and closed at $3.23 on Monday. One astute friend noted that you could now purchase a share of WaMu for less than a gallon of gas.
The failure of IndyMac and rumors of other problems lead us to review the rules of the Federal Deposit Insurance Commission (FDIC). If one of the nation’s banks fails, the FDIC protects individual accounts up to $100,000 per deposit per bank or $250,000 for most retirement accounts. Some have wondered why the amounts remain at these levels despite inflation, but the reality is that by law, the FDIC can’t increase the coverage until 2011. However, even if you have more than $100,000 in the account, you may be partially reimbursed. In the case of IndyMac, regulators believe that depositors will eventually get 50% of the uninsured amounts.
[There is an important note for those who use a bank for saving and investing: the FDIC does not insure money invested in stocks, bonds, mutual funds, life-insurance policies, annuities or municipal securities, even if these investments were bought from an insured bank. Those assets are usually covered by Securities Investor Protection Corporation (SIPC), which covers up to a ceiling of $500,000 per customer, including a maximum of $100,000 for cash claims, held by a customer at a financially troubled brokerage firm.]
If you have more than the $100,000 in an account, one way to protect yourself is to spread out your money at a variety of institutions. If you think that’s too much of a pain in the neck, then open different accounts—an individual account for you, one for your spouse and then perhaps a joint account for the two of you. That way, you can maintain $100,000 per account. Make these changes before bad news emerges, because the FDIC does not create a warning for banks that are in trouble.
Friday, July 18, 2008
Thursday, July 17, 2008
How Do You Spell Relief? R-A-L-L-Y!
I walked into the office yesterday morning thinking, that having the S&P 500 down 17.3% year-to-date does not make for a happy Wednesday for most people. I actually felt pretty good because our portfolios have been able to weather the storm pretty well. Still, most clients are down, so telling Mr. Jones that he is down “only” 6% still means that he is in a bad mood.
The only thing that could provide a bit of relief for every Mr. and Mrs. Jones out there was a stock market rally and boy, did we get a reprieve yesterday! Led by the beleaguered financial sector, the Dow Jones Industrial Average leapt 276.74 points, or 2.5%, to 11239.28 and the S&P 500 also soared 2.5% to 1245.36. The S&P 500 financial sector finally shot up after five consecutive down days in which it sagged 16.4%, leaping 12.5%. Bank of America skyrocketed 22.4%, Wells Fargo shares soared 32.8%, Lehman Brothers, which had been on “death watch” gained 20.6%, while troubled GSEs Fannie Mae and Freddie Mac rose more than 29% each. (Although the NASDAQ is not filled with financial companies, it too enjoyed the day’s bull run, rising 3.1% to 2284.95.)
What made investors go on a buying binge yesterday? The early economic report that grabbed headlines was the June Consumer Price Index, which jumped 1.1%, the second-biggest rise since 1982. Obviously the inflation news was not exactly good news, but the core number was close enough to expectations that investors did not get too worried. Other news included the Securities & Exchange Commission’s announcement that it was moving to curb short sales, which might have spurred a short-covering rally. Then there was the release of the FOMC minutes from the June 24-25 meeting, which detailed an internal discussion about what to do going further, which led many to believe that the Fed will not act any time soon.
The oil market helped to provide relief to investors. After falling $6.44 on Tuesday, light, sweet crude for August delivery settled $4.14, or 3%, lower at $134.60 a barrel on the New York Mercantile Exchange. Crude oil futures have dropped $10.58, or 7.3%, over the last two sessions on concerns that a prolonged economic downturn in the US and Europe will create demand destruction that can not be overcome by slowing Asian economies. For months, oil has been the main driver for almost every asset class so it stands to reason that a pull-back would provide the opportunity for investors to reconsider their overly bearish bets.
In the end, the main catalyst for a day like yesterday may be relief as much as any data points. The market has been weighed down by overly negative sentiment, which needed to be corrected. Of course one day does not make a trend, but after the past six weeks, investors enjoyed the respite of a spring-back in stock prices. Now we need to see whether follow through ensues or if we are doomed to stay mired in a downtrend. For now, you can spell relief with R-A-L-L-Y.
The only thing that could provide a bit of relief for every Mr. and Mrs. Jones out there was a stock market rally and boy, did we get a reprieve yesterday! Led by the beleaguered financial sector, the Dow Jones Industrial Average leapt 276.74 points, or 2.5%, to 11239.28 and the S&P 500 also soared 2.5% to 1245.36. The S&P 500 financial sector finally shot up after five consecutive down days in which it sagged 16.4%, leaping 12.5%. Bank of America skyrocketed 22.4%, Wells Fargo shares soared 32.8%, Lehman Brothers, which had been on “death watch” gained 20.6%, while troubled GSEs Fannie Mae and Freddie Mac rose more than 29% each. (Although the NASDAQ is not filled with financial companies, it too enjoyed the day’s bull run, rising 3.1% to 2284.95.)
What made investors go on a buying binge yesterday? The early economic report that grabbed headlines was the June Consumer Price Index, which jumped 1.1%, the second-biggest rise since 1982. Obviously the inflation news was not exactly good news, but the core number was close enough to expectations that investors did not get too worried. Other news included the Securities & Exchange Commission’s announcement that it was moving to curb short sales, which might have spurred a short-covering rally. Then there was the release of the FOMC minutes from the June 24-25 meeting, which detailed an internal discussion about what to do going further, which led many to believe that the Fed will not act any time soon.
The oil market helped to provide relief to investors. After falling $6.44 on Tuesday, light, sweet crude for August delivery settled $4.14, or 3%, lower at $134.60 a barrel on the New York Mercantile Exchange. Crude oil futures have dropped $10.58, or 7.3%, over the last two sessions on concerns that a prolonged economic downturn in the US and Europe will create demand destruction that can not be overcome by slowing Asian economies. For months, oil has been the main driver for almost every asset class so it stands to reason that a pull-back would provide the opportunity for investors to reconsider their overly bearish bets.
In the end, the main catalyst for a day like yesterday may be relief as much as any data points. The market has been weighed down by overly negative sentiment, which needed to be corrected. Of course one day does not make a trend, but after the past six weeks, investors enjoyed the respite of a spring-back in stock prices. Now we need to see whether follow through ensues or if we are doomed to stay mired in a downtrend. For now, you can spell relief with R-A-L-L-Y.
Wednesday, July 16, 2008
Fannie Freddie Freak Out: Part Two
Yesterday I talked about some of the basic facts about the two Government Sponsored Enterprises, mega-mortgage facilitators Fannie Mae and Freddie Mac. Today let’s turn our attention to the implications of the story—how does the bad behavior of your kooky old relatives, Fannie and Freddie, affect you?
The first question that comes to mind is, “What happens if either Fannie or Freddie were involved with my mortgage?” The answer is easy: NOTHING. Even if the government literally took over the two companies, which has not yet occurred, keep paying your monthly mortgage! In fact, paying your mortgage on time should always be your number one financial priority.
The more interesting question is what might happen to the general mortgage market for those who are interested in re-financing or those seeking a brand new mortgage? Without Fannie and Freddie, the market for mortgages would be even tougher than it is now. Together Fannie and Freddie have bought 80% of new mortgages in the US this year from banks and mortgage lenders -- losing that demand would be deadly for the already-beleaguered housing market, which is why the government is doing everything in its power to ensure that the companies continue to function.
But the whole thing is circular: when there are too many homes for sale, prices plunge, lowering the value of the assets on Fannie and Freddie’s balance sheet. With less capital available, the two kooks reduce the amount of lending activity or are forced to raise the cost of a loan. Concurrently, when prices fall, it leads to more foreclosures, as homeowners find it nearly impossible to refinance their existing mortgages. This “negative feedback loop” can build on itself and become a self-fulfilling nightmare, which throws the economy and the financial markets into disarray. (Conversely, some have estimated that if Fannie and Freddie were in stronger financial shape, mortgage rates could be lower by as much as a quarter of a point, helping to heal the housing markets.) This is why the government had to announce a plan to stop the bleeding.
On Sunday, the Bush administration asked Congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investments and loans. In a separate announcement, the Fed said that it would make one of its short-term lending programs, the so-called “discount window”, available to Fannie Mae and Freddie Mac. If these actions do not do the job, Fannie and Freddie could fall under the control of their government regulator, which would then be responsible for the firm. That step -- known as placing it in a “conservatorship” would allow the mortgage company to continue operating, but how efficiently is unknown. Clearly, this would be a last resort for the government.
For those who want “someone to pay”, don’t worry: shareholders of the two companies have lost approximately 80% of the value of their investments this year alone. I don’t know about you, but that does not make me feel too good in this environment.
The first question that comes to mind is, “What happens if either Fannie or Freddie were involved with my mortgage?” The answer is easy: NOTHING. Even if the government literally took over the two companies, which has not yet occurred, keep paying your monthly mortgage! In fact, paying your mortgage on time should always be your number one financial priority.
The more interesting question is what might happen to the general mortgage market for those who are interested in re-financing or those seeking a brand new mortgage? Without Fannie and Freddie, the market for mortgages would be even tougher than it is now. Together Fannie and Freddie have bought 80% of new mortgages in the US this year from banks and mortgage lenders -- losing that demand would be deadly for the already-beleaguered housing market, which is why the government is doing everything in its power to ensure that the companies continue to function.
But the whole thing is circular: when there are too many homes for sale, prices plunge, lowering the value of the assets on Fannie and Freddie’s balance sheet. With less capital available, the two kooks reduce the amount of lending activity or are forced to raise the cost of a loan. Concurrently, when prices fall, it leads to more foreclosures, as homeowners find it nearly impossible to refinance their existing mortgages. This “negative feedback loop” can build on itself and become a self-fulfilling nightmare, which throws the economy and the financial markets into disarray. (Conversely, some have estimated that if Fannie and Freddie were in stronger financial shape, mortgage rates could be lower by as much as a quarter of a point, helping to heal the housing markets.) This is why the government had to announce a plan to stop the bleeding.
On Sunday, the Bush administration asked Congress to approve a sweeping rescue package that would give officials the power to inject billions of federal dollars into the beleaguered companies through investments and loans. In a separate announcement, the Fed said that it would make one of its short-term lending programs, the so-called “discount window”, available to Fannie Mae and Freddie Mac. If these actions do not do the job, Fannie and Freddie could fall under the control of their government regulator, which would then be responsible for the firm. That step -- known as placing it in a “conservatorship” would allow the mortgage company to continue operating, but how efficiently is unknown. Clearly, this would be a last resort for the government.
For those who want “someone to pay”, don’t worry: shareholders of the two companies have lost approximately 80% of the value of their investments this year alone. I don’t know about you, but that does not make me feel too good in this environment.
Tuesday, July 15, 2008
Fannie Freddie Freak Out: Part One
Like kooky old relatives who you sort of know but don’t really encounter until that fateful family event where they create a scene, the solvency of Fannie Mae and Freddie Mac have taken center stage as the most important financial issue right now. In fact, it may be the only story that can displace the Jolie/Pitt twins. Today and tomorrow I am going to explain why this story is so important and how it could affect you.
Let’s start with a little history lesson. Congress created Fannie Mae in 1938 as part of FDR’s New Deal to ensure money for home mortgages would be reliably available, while Freddie Mac was created by Congress in 1970 with a mission to provide liquidity, stability and affordability to the nation's mortgage markets. This was all done to help accomplish the national quest of home ownership for all (for more on my opinion on that topic, see my article from July 2, “Home Ownership Myths”).
Fannie and Freddie don't make home loans, but they provide stability and liquidity to the mortgage market by guaranteeing that investors who buy mortgage securities will receive timely payments of principal and interest. In practice, both companies buy mortgages, package them into securities and sell them to investors and also hold mortgages in their own portfolios. Combined, Fannie and Freddie own or guarantee about $5.2 trillion of the $12 trillion U.S. home-mortgage debt outstanding. The vast majority of the mortgages they back are fixed-rate, prime loans that went to borrowers with good credit, not the scary sub-prime stuff that has brought down other institutions.
Because Congress was involved with their formation, both entities are considered, “government-sponsored enterprises,” or GSEs, but they are both privately owned by shareholders. Despite being private, Fannie and Freddie receive special privileges, the most important of which is the widespread belief that if either fell on hard times, the government would be there for them. The government has consistently emphasized that it does not guarantee either Fannie or Freddie’s debts, but it is common wisdom that Uncle Sam would provide a safety net, which has allowed both to borrow money at lower interest rates, enabling them to make loans more cheaply. The other privilege that the companies enjoy is more lenient capital requirements, because regulators and Congress believed that there wasn't much risk of wide-spread defaults on home mortgages---a concept that sounds quaint at best, in light of the current housing mess.
The Fannie and Freddie advantage amounts to a strange situation where profits have been privatized but losses are socialized. In other words, if the companies do well, the shareholders make money. But, if the bets go sour, the government (meaning you and me, of course) eats the losses. If this isn’t the definition of moral hazard, what is? If you know that you get to keep the marbles when you bet big, but Uncle Sam carries you on his back if you blow it, wouldn’t you assume a lot of risk?
This is a system that encouraged lots of leverage, which means that any change in the underlying value of the assets can wreak havoc on the companies. Looking at Fannie and Freddie’s balance sheets at the end of last quarter, you see that there is a face value of $1.7 trillion in mortgages, supported by assets of $70 million in core capital. Combined, that equates to leverage of 24 to 1, but when you add in their off-balance sheet guarantees, the figure rises to almost 70 to 1! You don’t need to be an economist or an accountant to know that with home prices plummeting, this bet went sour fast and furiously. Tomorrow, I will review how Fannie and Freddie’s problems could affect you.
Let’s start with a little history lesson. Congress created Fannie Mae in 1938 as part of FDR’s New Deal to ensure money for home mortgages would be reliably available, while Freddie Mac was created by Congress in 1970 with a mission to provide liquidity, stability and affordability to the nation's mortgage markets. This was all done to help accomplish the national quest of home ownership for all (for more on my opinion on that topic, see my article from July 2, “Home Ownership Myths”).
Fannie and Freddie don't make home loans, but they provide stability and liquidity to the mortgage market by guaranteeing that investors who buy mortgage securities will receive timely payments of principal and interest. In practice, both companies buy mortgages, package them into securities and sell them to investors and also hold mortgages in their own portfolios. Combined, Fannie and Freddie own or guarantee about $5.2 trillion of the $12 trillion U.S. home-mortgage debt outstanding. The vast majority of the mortgages they back are fixed-rate, prime loans that went to borrowers with good credit, not the scary sub-prime stuff that has brought down other institutions.
Because Congress was involved with their formation, both entities are considered, “government-sponsored enterprises,” or GSEs, but they are both privately owned by shareholders. Despite being private, Fannie and Freddie receive special privileges, the most important of which is the widespread belief that if either fell on hard times, the government would be there for them. The government has consistently emphasized that it does not guarantee either Fannie or Freddie’s debts, but it is common wisdom that Uncle Sam would provide a safety net, which has allowed both to borrow money at lower interest rates, enabling them to make loans more cheaply. The other privilege that the companies enjoy is more lenient capital requirements, because regulators and Congress believed that there wasn't much risk of wide-spread defaults on home mortgages---a concept that sounds quaint at best, in light of the current housing mess.
The Fannie and Freddie advantage amounts to a strange situation where profits have been privatized but losses are socialized. In other words, if the companies do well, the shareholders make money. But, if the bets go sour, the government (meaning you and me, of course) eats the losses. If this isn’t the definition of moral hazard, what is? If you know that you get to keep the marbles when you bet big, but Uncle Sam carries you on his back if you blow it, wouldn’t you assume a lot of risk?
This is a system that encouraged lots of leverage, which means that any change in the underlying value of the assets can wreak havoc on the companies. Looking at Fannie and Freddie’s balance sheets at the end of last quarter, you see that there is a face value of $1.7 trillion in mortgages, supported by assets of $70 million in core capital. Combined, that equates to leverage of 24 to 1, but when you add in their off-balance sheet guarantees, the figure rises to almost 70 to 1! You don’t need to be an economist or an accountant to know that with home prices plummeting, this bet went sour fast and furiously. Tomorrow, I will review how Fannie and Freddie’s problems could affect you.
Monday, July 14, 2008
Break out of your Bastille
Today, France commemorates Bastille Day, which is similar to our Independence Day. For centuries, kings and queens ruled France and squashed those citizens who disagreed with them. They would often toss dissenters into The Bastille, or prison, which became the symbol of the worst aspects of the monarchy. On July 14, 1789, a large number of French citizens gathered together and stormed the Bastille, kicking off the French Revolution. In the end, the war proved that power no longer resided in the King, but in the people.
Today I want to start to equate the Bastille with a similar, though perhaps more insidious prison. The financial equivalent to the Bastille is something we ourselves build – too many people are prisoners to a lifestyle they can not afford. I thought about this after speaking with a young couple who purchased a house that was a stretch, but doable as long as the husband used his annual bonus to augment the household income of $250,000. Things went smoothly for the first year, but this year, the bonus was half of last year’s take. Flash forward six months and I am on the phone with a guy who has amassed thirty grand in credit card debt.
After running through the easiest suggestion -- refinance the first mortgage, the line of credit and the credit card debt into one thirty year fixed rate mortgage, we got down to it. “I know that I hardly know you, but I need to state an obvious fact: You can’t afford your lifestyle and you are going to have to make some difficult decisions.” After twenty minutes, we had found exactly $30,000 of extras that they could cut, including the country club and the fancy vacations. The guy was not happy, but I promised him that if he could “get by” without these things, he would likely sleep better.
I have heard theses stories up and down the food chain, from the multi-millionaires who can’t figure out how to make it on $20 million, to the guy who earns $500K, but is broke, to the family that makes $100,000 and is having difficulty making ends meet. I know that’s hard to imagine, but each one really does not look up or down, rather he compares himself to his peer group.
With surgical precision, I try to identify the source of the problem without judgment. Once the people on the other side of the table get serious, they can easily slice and dice their way down to the essentials. For those who don’t have too much, it may be something simple, like stop buying lunches and coffee. For the millionaires, it may be the sale of the extra “fun” car or the need to rent the summer house for a month.
What is remarkably similar is that at each level, so many people have reached for a lifestyle they simply can not afford. For the sake of feeding their desires or keeping up with their neighbors, they are now living in the Bastille, wondering how they can earn freedom. Of course nobody is keeping you in the jail except yourself. But that’s actually the good news, because you hold the keys to your own financial freedom. Sure it might be painful at first, but could anything be worse than living in that Bastille that you built?
Today I want to start to equate the Bastille with a similar, though perhaps more insidious prison. The financial equivalent to the Bastille is something we ourselves build – too many people are prisoners to a lifestyle they can not afford. I thought about this after speaking with a young couple who purchased a house that was a stretch, but doable as long as the husband used his annual bonus to augment the household income of $250,000. Things went smoothly for the first year, but this year, the bonus was half of last year’s take. Flash forward six months and I am on the phone with a guy who has amassed thirty grand in credit card debt.
After running through the easiest suggestion -- refinance the first mortgage, the line of credit and the credit card debt into one thirty year fixed rate mortgage, we got down to it. “I know that I hardly know you, but I need to state an obvious fact: You can’t afford your lifestyle and you are going to have to make some difficult decisions.” After twenty minutes, we had found exactly $30,000 of extras that they could cut, including the country club and the fancy vacations. The guy was not happy, but I promised him that if he could “get by” without these things, he would likely sleep better.
I have heard theses stories up and down the food chain, from the multi-millionaires who can’t figure out how to make it on $20 million, to the guy who earns $500K, but is broke, to the family that makes $100,000 and is having difficulty making ends meet. I know that’s hard to imagine, but each one really does not look up or down, rather he compares himself to his peer group.
With surgical precision, I try to identify the source of the problem without judgment. Once the people on the other side of the table get serious, they can easily slice and dice their way down to the essentials. For those who don’t have too much, it may be something simple, like stop buying lunches and coffee. For the millionaires, it may be the sale of the extra “fun” car or the need to rent the summer house for a month.
What is remarkably similar is that at each level, so many people have reached for a lifestyle they simply can not afford. For the sake of feeding their desires or keeping up with their neighbors, they are now living in the Bastille, wondering how they can earn freedom. Of course nobody is keeping you in the jail except yourself. But that’s actually the good news, because you hold the keys to your own financial freedom. Sure it might be painful at first, but could anything be worse than living in that Bastille that you built?
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