Monday, September 8, 2008

Is big brother out of control?


Last week the two Government Sponsored Entities, (GSE's) Fannie Mae and Freddie Mac told us that they did not need additional capital. These entities also reported that they were experiencing the best net profit margins in ten years. The credit rating agencies had all the preferred stocks rated AA, second highest in investment quality. Because of this news both the common and preferred stocks rallied nicely. On Sunday, Fannie Mae and Freddie Mac were taken over by Treasury Secretary Henry Paulson and the Federal Government. They suspended the dividends on both the common and preferred stocks in their take over.

Many people, including many of my clients and myself saw the value of our preferred stock fall by 75% on Monday with no certainty as to when if ever we will ever get our money back. In fact, the discussions as to what to do with the GSE’s will not begin in earnest until the new Congress is sworn in January, 2009. No one knows what the outcome will be from these discussions in Congress or how long it will take Congress to come up with the answers.

When Secretary Paulson was asked today, “What should happen to the two entities?’ he responded, “I don’t know.” It seems to me that if you don’t know what to do with something when you take control of it you shouldn’t take control. In my opinion somebody was lying to us. How can investors make decisions if they do not have accurate information. If we can’t trust the companies and the rating agencies especially after the Bear Stearns and the sub-prime problems, then who can we trust?

I have to admit I was angry on Sunday afternoon when I read the announcement, because the companies and the rating agencies told us that things were OK. Yes, there were problems in the mortgage market, but when you hear statements from the companies that their margins were the best in 10 years.” You have to wonder if you have been lied too. When major investment banks say they will be OK and when the Chairman of the House Financial Service Committee, Mr. Barney Frank, says thing will be OK, you have to wonder how all of these forecasters got it wrong.

In American we pride ourselves that we have the greatest transparency of all the markets around the world. Where do you draw the line between what is being said to the public and what is going on in the bowels of the company that may be withheld from the investors? Do I feel like I have been lied to in this case? Yes and I think by a great many people.

The reason I bought these preferred stocks was because I have always seen them as debt instruments. Unlike common stocks, which are direct ownership of the company, preferred stocks are higher up the credit list than common stocks so you do not have the risk of common stock ownership. I could understand the elimination of the dividend on the common, but not the preferred's.

I am sure that many people and institutions feel the same way I do and they are angry about the way they have been treated. You make investment decisions on what you have been told. If the information is false then you have a right to know why it was wrong and you should not have to pay the price if you were misled. We need some appeal process to get all the facts and some level of restitution.

The market implications to this decision are vast and may be very dangerous both near-term and long-term. Let me give you some examples:

Bank and insurance companies bought these preferred to back up their liabilities to policyholders and depositors. We know that the Bank regulators have already sent notices to all banks that they must market their investments to the market reflecting the decline in value of the preferred. I fully expect the state insurance departments to issues similar orders for Life and P&C companies.

Some corporations have purchased these investments under the marketable securities section of the balance sheet. These balance sheets will have to be adjusted and the report to the public show the significant decline in value. Lastly, lets look at all the foreign investors including governments who have purchased these investments and now have them at to 30 cents or less on the dollar. What is the likelihood that they will want to buy other fixed income securities from the United States again? How will the rest of the preferred market be affected?

Is it possible that what they are doing will really work to solve the problem in housing? What if it does not, what else does the government want to own? Is this another case of "Big Brother" reaching beyond where it should?

We lost Bear Sterns because the market was concerned about sub-prime risk and the Fed stepped in, took control, and sold the company to JP Morgan Chase. We apparently did not have a problem with the GSE at least by public account, but the Treasury found a problem, stepped in, and took control again at a significant cost to investors. In both cases, the investors lost money and in the case of the GSE’s I still question the validity of the decision.

I fully expect that there will be legal action on behalf of the common stockholders and the preferred shareholders who have born the brunt of the loss while the bond holders are secured by the government. Every investor has to make his own decisions, but I for one will join the suit if there is one filed.

Dan Perkins


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