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INVESTING: Investors shrugging off home-mortgage turmoil

December 3, 2007

Nov. 20 was one of the stranger days in the stock market that I have seen for some time. On the surface, it came and went like any other business day, with the Dow Jones industrial average ending up a decent 50 points. However, if you had told me the stock prices of both the Federal Home Loan Mortgage Corp. and the Federal National Mortgage Association would collapse 25 percent that day even as the Dow rose, I would have called in the men with white coats and had you committed. Yet, that is what transpired.

Known as Freddie Mac and Fannie Mae, these institutions are "governmentsponsored enterprises," or GSEs, and are the largest buyers and guarantors of home loans in the country. Their activities facilitate the flow of money available for home loans. And while there is no expressed government guarantee, the investing public generally assumes these two companies have the implicit backing of the U.S. government.

The plunge in both stocks was triggered by Freddie Mac's third-quarter loss of $2 billion, due to the now-familiar affliction of mortgage foreclosures. Their combined one-day loss of $15 billion in market value came on the heels of the precipitous decline in another of the country's largest financial institutions, Citigroup. Over the past month, Citigroup's stock has shed more than $85 billion of market value.

In spite of the startling losses suffered by major U.S. financial institutions, stock investors are taking the upheaval in the credit markets amazingly well. Yes, the stock market has dropped some 7 percent so far in November, but for the year, the broad market averages are hovering near unchanged.

Thus the obvious question: Is the stock market correct to largely ignore the damage in the financial and housing sectors, or are we in for further, and perhaps painful, declines?

It is easy to paint a bleak market scenario considering all the debt that has been used to leverage assets. If our economy were to go into recession, the subprime mess could spill over to the junk debt used to finance private equity acquisitions and into consumer loans like credit cards and autos.

On the other hand, the glass-is-half-full group will speak of the market's discounting mechanism, in that all the bad news is already factored into stock prices. The strength of the global economy will allow us to muddle through and avoid a recession, these optimists say. Another key argument you'll hear from this crowd: Stocks are cheap when viewed against our low interest rates.

Regardless, what can be said with certainty is that this period of consternation will take time to sort out. The pathetic irony is that many of the loans that now are inflicting losses are the very same securities that were created in securitizations months ago and were the source of the record earnings and compensation for Wall Street firms. The fat bonuses will be paid at year-end, despite the morass.

Be prepared for more head-scratching days in the market like Nov. 20. Yet recognize that peak periods of risk and fear are typically great times for long-term investors to buy.



Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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