A few days ago I was depressed. Moody's downgraded the GSE preferreds five notches and I thought the rout may have been on. However, positive comments from a Wall Street research department and guests on CNBC (whose positive comments stunned the muckraking hosts) stabilized the GSE preferred market.
Even the most ardent GSE basher and nationalization advocate has to consider the repercussions of wiping out preferred investors when many regionals and major banks, such as JP Morgan, are loaded up with GSE preferreds. This is in addition to insurance companies such as Safeco and Allstate and pension funds such as TIAA-CREF.
Of course, the new spin is that firms such as JPM will have to take substantial writedowns because of GSE preferred positions. The fear-mongering is gearing up for another round of "Frighten Investors" The difference between GSE writedowns and CDO / SIV writedowns is that there is a good chance that, in the -not-too-distant future, investors in GSE preferreds wil be writing them up. Many, if not most, CDOs and SIVs are not going to be written up appreciably as the collateral within has defaulted. It is cents on the dollar for these puppies.
Whether or not you agree with Fed Chairman Bernanke, he has been successful, thus far, in stabilizing the banking system. Letting the GSE preferreds implode or even just suspend dividends would undo much of Mr. Bernanke's work. I can imagine him on the phone with Hank Paulson begging him not to wreck the financial system.
Fortunately, not only does Mr. Paulson not want to take over the GSEs, he cannot do so without their consent. Lets get past this nationalization talk, for now.
Investors have really been through hell during the past 12 months. From AAA-rated mortgage-backed securities, to auction-rate securities to the GSEs, investors have been hammered from some unlikely corners of the market. For these investors I have good news. It will get better.
It will get better, but investors should manage expectations. It took six years of accommodative Fed policy to cause the housing / credit bubble. Hubristic strategies and decisions made by academically-gifted people evolved over time. It is going to take a long time, possibly years, for another group of academically-gifted people to work the markets out of this mess (I would do nearly anything to have old-time traders back in charge).
Investors should also manage expectation as to how robust the recovery will be. Brokers and banks are not going to approach earnings levels seen during the past several years. I am not just talking about profits, but also revenues. Home prices will stabilize and gradually recover, but they are not returning to their cheap money / no documentation levels any time soon.
As with the tech bubble, investors reminisce and call for a return to those halcyon days when 401Ks would rise 20% or more per year. That wasn't real. That was too many investors trying to get in on the action at once. When they all raced for the door on the way out, the boom turned to bust. That happened with the credit bubble and, to a lesser extent, the recent commodities bubble.
Nearly all bubbles have fundamental origins, but enthusiasm takes over and asset prices spiral out of control. Bubbles can also work in reverse. There is no way that the significant problems in the financial sector justifies the trading levels of their preferreds and some of their bonds. Investors with the stomach for volatility can pick up bargains.
Many readers have asked me about the safety of senior GSE debt. This debt has an implied government guarantee which would only be strengthened in the unlikely event of a GSE nationalization. The fear-mongers tried to scare investors by stating all could be lost for the GSEs if they cannot raise money to fund their mortgage businesses. Last week, FRE came with a $3 billion five-year note. Today, FNM did the same. Both syndicates were oversubscribed. So much for not being able to raise capital.
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