Primordial Scream, Economic-Style

It's times like these I just want to tear my hair out. I just bought some FHN (under 2,000 dollars' worth, so I am not including them in my Stocks Update), as well as another 100 shares of CNB. But CNB went down around 13% today, so now I have 1100 shares and a lot less confidence in my stock picking abilities. After the Fed Reserve came out and assured everyone that FNM and FRE would not go under, small bank stocks still went down based on the IndyMac collapse, a poor earnings report from M&T Bank, and National City's woes. All three banks were having issues, which reflected on FHN and CNB.

Still, FHN and CNB are priced as if they are going to fail. That is far from the case. The "Texas ratio" is a good financial rule of thumb that assists investors in determining whether a bank will fail. The ratio is calculated by dividing a bank's non-performing loans, including those 90 days delinquent, by the company's tangible equity capital plus money set aside for future loan losses. The Texas ratio shows to what extent a bank is overleveraged; how well its loans are doing; and whether it has the capital to continue suffering losses on loans without failing or needing to raise more capital. Any ratio 100 or over means the bank may fail and is in the zone of bankruptcy. IndyMac had a Texas ratio of 125 prior to its collapse. But FHN and CNB have Texas ratios of around 25%. CNB releases earnings on July 21; FHN releases earnings on July 17 [Update: FHN released earnings today after its stock price went down 25%; in afterhours trading it was up 5%].

USB releases earnings tomorrow. It is said to be a much more stable bank, and its earnings may provide better guidance about whether CNB and FHN will have good news this week and next week.

If any major bank is going to go under, I don't think it's going to be CNB or FHN. Unless their earnings/losses are especially horrendous--and their stock prices reflect normally horrendous losses--they should be okay. The word on the street is that Washington Mutual is teetering on the brink. I have an account there, and I am not concerned because FDIC insurance will protect my deposits and my clients' deposits.

These are truly crazy times for banks and American capitalism. I hope two years from now, my readers and I can read this posting and smile. Right now, however, I am just shocked at how irrational this market is. "Encephalic apoplexy" seems like an appropriate term to describe what I am feeling, because I am used to being right about the market.

[On the bright side, I did successfully day-trade some GE shares today.]

Stocks Update

I had sold some PFE at 18.33 but still hold many shares. I sold my GE prior to the earnings report, taking the 6% loss. I added to my CNB position, which swung from an unrealized 3% gain to an unrealized 11% loss. I also received dividends, which are not factored into the calculations below. If I pick stocks well, my picks should do well even without factoring in dividends.

Thus far, it appears I am doing slightly better than the overall market, but this is bittersweet, given that the S&P 500 has lost over 10% in less than two months. I had removed most of my money from the market two months ago, so I am not concerned--yet. "The market can stay irrational longer than you can stay solvent," the saying goes. Thankfully, all of my open positions are in retirement accounts, so I can wait for years until the market becomes rational again.

One benefit of keeping track of my trades is I can see which styles work for me. So far, it is clear I am better off with short term trades (100% positive record) than long term ones. I place very large bets when making short term trades, and smaller bets when establishing longer term positions. Therefore, it's as if I bet 5,000 dollars on red in roulette, win quickly, but then give some of my gains back when I overestimate my intelligence and go play poker for a few hours with a 1,000 dollar buy-in.

Open Positions
CNB = -11.5
EQ = -8.0
EWM = -8.54
IF = -11.8
PFE = -7.22

Average of "Open Positions": losing/negative average of 9.41%

Closed Positions:
Held more than seven days but less than one year:
GE = -6.4
PNK = -16.7%
PPS = -2.8
WYE = +2.4%

Held less than 7 days:
GE (1.0%); ICE (2.0%), MMM (0.5%), MRK (0.1%), PFE (1.3%), SCUR (15%) (Overall record in this category is a 3.31% average gain)

Daytrades:
PFE = +0.5%
GE = +0.5% (Updated on July 14, 2008; bought at 27.15, sold at 27.30)
XLF = +4.3% (Updated on July 15, 2008)

Average of "Closed Positions" sub-categories, except for Daytrades: losing/negative 4.59%

Combined Total Averages, excluding Daytrades: losing/negative 7.0%

Compare to S&P 500: losing/negative 10.5%
[from May 30, 2008 (1385.67) to July 13, 2008 (1239.49)]

The information on this site is provided for discussion purposes only and does not constitute investing recommendations. Under no circumstances does this information represent a recommendation to buy or sell securities or make any kind of an investment. You are responsible for your own due diligence.

Stock Market Week Recap: Fannie Mae and Freddie Mac

Contrary to my belief that GE's earnings would be some kind of bellwether for the overall market, Fannie Mae and Freddie Mac stole the show. GE had set expectations so low, when it beat its own lowered expectations, the market barely noticed.

Meanwhile, Fannie (FNM) and Freddie's (FRE) stock prices got cut in half after liquidity concerns arose. What are Fannie and Freddie, and why are they so important? I realized I didn't really know much about these institutions, which hold between five to six trillion dollars in debt.

According to its own website, FNM "operates in America's secondary mortgage market to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates." FRE's business sounds similar:

We connect Main Street – the residential mortgage market – to Wall Street – dealers and investors – through our mortgage purchase, credit guarantee and portfolio investment activities.

Our customers are predominately lenders in the primary mortgage market. Our activity in the secondary mortgage market supports a continuous flow of funds to the primary market, which leads to consumer benefits in the form of a steady flow of low-cost mortgage funding.

What is a secondary mortgage market? It's when a bank gives you a mortgage and then wants to spread its risk around. If it holds onto your loan, and you don't pay, then it is the only entity on the hook. But if it sells the right to future interest payments and/or principal in your loan to someone else, it reduces its reliance on one source of profit. Another way to reduce risk is to have more people involved in a deal, so if one person pulls out, there are plenty left to handle the remaining issues. So most banks re-package their mortgage loans and put them into one big "debt pie" (my own term) and then instead of holding onto the pie, they sell slices to other entities. The bank cuts the "debt pie" into several pieces, some better than others, and sells off its loans at different prices to investors who want to receive the monthly mortgage payments and/or interest.

FRE and FNM get a fee for repackaging various banks' mortgage loans and shouldering the risk that the borrower might not repay the principal or the interest. By allowing banks to place everyone and their mortgages into a large pie, the banks spread their lending risks and possibly get some immediate cash back to make more loans.

The problem is that the pie slices kept getting sold off to more and more buyers through even more complex financial instruments. When the music stopped, everyone forgot that someone had to pay the original mortgages or the game couldn't continue. Ironically, by trying to reduce the risks of lending, banks and FNM/FRE actually increased overall risk, because no one had an interest in making sure the original borrower paid up. The geniuses on Wall Street created no incentive to make sure the guy at the bottom had the papers or the income or the willingness to pay his/her mortgage, because everyone assumed that the original bank checked out the papers and did the due diligence. As we know, loan agents didn't always require tight documentation before submitting loan applications, but the banks that received the applications didn't care, because they knew they could put the loan into a large pie and sell it off and get paid. In violation of the philosopher Kant's ethical guidelines, the banks treated people as a means to an end, rather than an end, knowing they could dump the loans on someone else because FNM and FRE would guarantee them.

The U.S. government has decided that in order to encourage people to buy homes, it needs to support companies (FNM and FRE are both publicly traded and owned by shareholders, not the government) willing to buy up the "debt pies." It supports them by offering loans from the Federal Reserve's discount window, currently at 2.25%. Without this kind of support, the government believes banks would be less willing to make mortgage loans, thereby causing housing prices to decrease. Because most Americans have most of their net worth in their homes, if housing prices decrease, it would make them feel more poor and less willing to spend, causing a recession. As a result, the government has lent an implicit promise to FNM and FRE that they can make loans and will receive liquidity from the government to support American home ownership. This "promise" isn't written down anywhere, but the amount of debt pies held by FNM and FRE are staggering--again, it's around half the entire mortgage loan market, or around 5 to 6 trillion dollars. They are "too big to fail," as some might say.

Recently, the Federal Reserve, which holds taxpayer money (read: our money) refused to loan more money to FNM or FRE, causing their stock prices to decrease by around 50% [This just in: the Fed Reserve Bank of New York will lend money to FNM and FRE]. [Still,] In a worst case scenario, FNM and FRE have been guaranteeing mortgage loans that can't be repaid, in which case they have to reduce their mortgage guarantees, diminishing further demand in the housing market.

At the same time, this might be a welcome development, because by reducing the availability of mortgages, housing prices might decrease enough to allow more first time buyers to buy homes. A friend of mine reminded me not everyone should buy a home--some people are better off in apartments. This reality caused some cognitive dissonance because I am a firm believer in the American Dream including a home, but he is correct. Not everyone can afford to buy a home--some people's incomes are not steady or high enough to guarantee their ability to pay property taxes and repairs, much less the monthly payments on a home. In addition, FNM and FRE's business models work best if you assume housing prices will always increase, allowing homeowners to refinance to pay their mortgages in lean times or during a layoff. But there is no guarantee that housing prices will keep increasing, nor should the government "guarantee" infinitely increasing property prices. The problem, of course, is it looks like the government has done just that.

It appears that when the Fed lowered interest rates post-9/11, basically making money free to the public, it gave everyone a green light to buy a home. In retrospect, Mr. Greenspan didn't really have a choice--he had to open the money spigot to bring back American confidence. But neither Mr. Greenspan nor anyone else thought an Iraq war would last several years, or that oil would increase to 160 dollars a barrel. Therefore, people who blame Greenspan might want to look in the mirror first--the Iraq war, which the Democratic Congress continues to finance, has contributed to taking trillions out of the United States' economy and into non-productive areas, destroying the value of the American dollar. In time, when Iraq's oil fields are producing oil at full capacity, the war might make more sense. But for now, Congress needs to commit to a balanced budget and restore the world's faith in the American dollar. Fannie and Freddie are just symptoms of an overall refusal by our government to restrict spending.

On a personal note, I can't figure out the difference in FRE and FNM, but apparently, Congress approved FRE to counteract FNM's monopoly. If someone can explain the difference between Fannie and Freddie, please add to the comments section. In addition, I can't figure out if FNM and FRE just get paid a fee for buying the loans from the bank and then dumping them on someone else, or if they hold onto some percentage of the mortgage loans.

Also, do FNM and FRE line up a buyer for the loans in advance of buying them from the banks? If not, then they could be stuck with trillions of loans on their own books. If they do have loans on their books they can't dump on someone else, and they go bankrupt, what happens if the government doesn't bail them out? I think the banks would get screwed, but not the homeowner, as long as s/he's paying his mortgage. That means we could have major banking collapses, but that's a shareholder matter, unless the FDIC gets involved. It is also probably cheaper to pay FDIC guarantees than FNM/FRE loans. Of course, if the government doesn't support FNM/FRE, and lets the banks shoulder the risk, the entire banking system collapses, because Americans would take their money out of banks, causing an IndyMac situation (i.e., if bank deposit holders think their bank is going under, they will remove the capital the bank is using to fund other loans, causing the bank to collapse). Sigh. It really doesn't look good, folks. Any comments are appreciated.

Shareholder Meeting Tip

The Wall Street Journal published an unintentionally amusing blurb about Marks and Spencer's (M&S) shareholder meeting. Despite poor performance, M&S shareholders retained their CEO. The WSJ tried to explain the retention of the beleaguered CEO by saying, "Marks and Spencer may have helped lift the mood by offering the 1,636 investors free wine, cider, sandwiches and desserts beforehand." Compare that to Long's Drugs shareholder meeting, where they served just water and basic Milano cookies. A word to the wise in corporate departments: always have good refreshments or some kind of unique freebie at shareholder meetings--investors will give you free advertising and speak well of you, which provides a good return in the form of goodwill.

Real Inflation: Trimmed Mean PCE

It looks like the real inflation rate in May 2008 was 5%. See

http://dallasfed.org/data/pce/index.html

The United States still uses a grossly fallacious measure of inflation called, "core inflation," which excludes food and energy prices. This "core inflation" is reflected in a widely-used metric called the CPI, or Consumer Price Index. Using CPI numbers that exclude food and energy, if a tomato goes from 80 cents to 5 dollars each, but a Dell laptop gets cheaper by 100 bucks, the CPI would indicate that overall inflation was going down--which would be inaccurate. Thus, as a statistic, most "core" CPI numbers bring to mind the comment about "lies, damn lies, and statistics."

The Dallas Fed Reserve has bucked this misinformation trend by publishing a more accurate inflation statistic called "Trimmed Mean PCE," which includes energy and food prices. The Trimmed Mean PCE (personal consumption expenditures price index) more accurately reflects the real rate of inflation is because a) it usually includes food and energy prices; and b) it trims, or cuts, unusual numbers that are indicative of generalized noise rather than a long-term inflation signal. The United States' continued use of certain CPI numbers over a more inclusive indicator of inflation means that it is misleading the public, which still has not fully grasped how much money America has printed recently for extraneous expenditures.

For example, if annual inflation is at 4%, and your assets increased by 3%, you lost purchasing power. Money, after all, only has value because it is a means to buy things. If your ability to buy things decreases in the real world, even though the quantity of your money increases, you have fallen behind. America is currently experiencing about 5% inflation while the stock market has caused many portfolios to decrease by 10%, a double whammy. 5 dollars a gallon gas is just one obvious indicator of how massive federal expenditures have harmed the American Dream and Americans' ability to plan ahead financially. Still, if you look at most government figures for CPI, the government's numbers appear understated. The Fed Reserve is telling us that inflation is running at 4.2%, including food and energy, and 2.3% excluding food and energy. See CPI-U for 12 months ending May 2008 (link goes to PDF file):

http://www.bls.gov/cpi/cpid0805.pdf

But the Dallas Fed Reserve believes that inflation is running at 5%. Even the Fed Reserve member banks cannot get their story straight. Using several conflicting CPI numbers allows the federal government to keep printing more money, destroying its real value in the process, and then telling the public everything is okay and the government is properly evaluating inflation. Using a more focused, more accurate indicator of inflation would force the government to be more prudent in its expenditures. The public should be able to log onto the BLS website and get one or two numbers showing real inflation, instead of fifty different numbers. Other figures may still be listed on the government's website, but currently, there is no quick or obvious link to any PCE figure showing real inflation for the month of May 2008. Without such numbers, savers and workers cannot plan ahead to see how much they have to earn to maintain their standard of living.

Without accurate and easily accessible inflation information, a reckless government will print money to satiate the public in bad times, which allows the government to hide failed or short-sighted policies. The Medicare scheme is one such example of a failed government policy that is not being fixed partly because the government can mask the true cost of printing money in a barrage of irrelevant CPI statistics. As a result of public ignorance, the government can delay a real solution to Medicare's underfunded trillion dollar liabilities because it has the political go-ahead to print money to pay benefits if necessary. But, as one of my favorite quotes goes, "a few billion here and a few billion there, and pretty soon, you're taking about real money." That "real money" is the real value of money that savers have toiled to earn, and without more accurate inflation numbers, the United States makes it harder for its citizens to plan ahead and to justify delayed self-gratification.

There is one other interesting side note--the U.S. issues TIPs, or Treasury Inflation Protected Securities. These bonds are linked to inflation as measured by the "core" CPI numbers. These are very popular bonds, and the government may continue to issue billions of dollars' worth of them. As a result, the government has less incentive to shore up its CPI numbers, because doing so means it has to pay more money to the buyers of these bonds.

At the end of the day, a melange of irrelevant CPI figures favors spenders over savers because the more inflation statistics the government publishes that are irrelevant or not fully accurate, the easier it is to shield the public from the true consequences of government spending. The Federal Reserve should heavily advertise only a few inclusive inflation numbers and consider eliminating CPI, especially when PCE offers a more accurate inflation rate.

Update on July 11, 2008: according to my T Rowe Price newsletter, "inflation, as measured by the Consumer Price Index, was up to 4% for the one-year period ending March 31, 2008...U.S. inflation has historically averaged 3.1% for the 80-year period from 1926 through 2006."

Economics and "Common Sense" Quiz

There's a website that allows you to write your own quizzes--it's a little difficult to navigate, but it's quite good for a beta version. Here is my econ quiz--bonus points if you recognize the picture:

http://www.helloquizzy.com/tests/the-basic-common-sense-and-capitalism-test

Good luck!

Econ Calendar: Oh, Baby, Baby, It's a Wild World

GE releases earnings this Friday, and the day before, the unemployment numbers come out. So today, July 7, 2008, will either be the definitive bottom of the bear market, or we're in for a slow, somber decline if this week's numbers don't look good. Value investors might be salivating now, but as for me, well, I think Cat Stevens'/Yusuf Islam's lyrics are particularly apropos:

Now that I've lost everything to you
You say you wanna start something new...

Mr. Market has taken investors' money but now appears to be starting a new upward trend. And yes, I am being melodramatic--I called the recent market decline and got most of my money out, and if I hadn't jumped back in so soon with Pfizer (PFE), I'd be all smiles. As it stands, I still like PFE, GE, and CNB, because I can hold these stocks for the next five years or more. For long-term investors, perhaps today's V-shaped day can be the start of something new. Of course, "remember there's a lot of bad, and beware," and "a lot of nice things turn bad out there." To see Mr. Stevens in all his glory, check out the video after the jump:

http://www.youtube.com/watch?v=DHXpnZi9Hzs

The information on this site is provided for discussion purposes only and does not constitute investing recommendations. Under no circumstances does this information represent a recommendation to buy or sell securities or make any kind of an investment. You are responsible for your own due diligence.