Beauty lies in the eyes of beholder, and in today's markets, a company's worth lies in the hands of short traders. Short sellers are not only forcing companies like Fannie Mae (FNM) and Freddie Mac (FRE) to the brink of extinction, but they are also devouring the very roots of our financial system. And to aid them we have our exceptionally bright financial analysts and economists who are falling head over heels to get on CNBC, Bloomberg or may be even Discovery Channel to pronounce that every single financial institution in USA will be dead in next few days. And remember that these are the very same bright and smart people who until September 2007 (that seems a long time ago though) were telling you that market will keep breaking all the records forever. That didn't turn out to be true, and they are not right even this time. My first question for them will be, if you are really so smart to analyze another institution's balance sheet, then why didn't you analyze your's first.
Hopefully a few people will beg to differ and try to bring out the truth.
Let's start with Fannie (FNM) and Freddie (FRE). They hold almost half of 1.5 trillion dollar (equal to $750 billion) mortgages in this country. And suddenly investors are being forced to believe that every single dollar of it won't be paid back? How ridiculous is that? The term of a typical fixed-rate mortgage runs at a minimum of 15-30 years, and for an ARM it can be anywhere between 3/5/7/10 years. Considering that even 50% of people are defaulting presently puts $350 billion dollars of these companies at stake.
At the end of past quarter, Fannie had almost $843 billion in long-term and short-term assets. They had earmarked $1 billion for losses. Even if you consider it a conservative estimate, only naive investors would believe that all of $843 billion are going to result in bad loans. And are we ready to believe that housing will be in the same bad situation even 2 years from now? No, that's not true. House prices will start rising very soon, again, if not for any other reason than for the simple reason that the cost of raw materials for building a new houses is increasing at a much faster pace. That will automatically improve the pricing of existing homes as well.
To give an example, I'm trying to buy a house in Texas and builder there is not open for negotiating even $2000 extra. A friend of mine, who recently moved to California, told me that the house prices there are still going up (don't laugh at it, these are the areas where you want to live and not some shady part of the town). So if you believe that every single loan that Fannie and Freddie hold will go in default, that their only customers are people with subprime credit and that house prices will be declining even 5 years from now, then go ahead and short these companies. You might still get some juice left. But, based on what I tried to explain above, you can maybe be a buyer at these very attractive levels and get a minimum of 100-150% return in eight to twelve months time.
Another good opportunity lies in the investment banks, which have been dragged down by current mess and market rumors.
Lehman Brothers (LEH), with a 44% decline in just 5 days, is a prime stock. Short selling money managers want to make us believe that all the business of Lehman was just tied to Fannie and Freddie. And that Lehman will fail just because Bear Sterns (NYSE:BSC) failed. First of all, with access to Fed's discount window (that will now be available well into 2009 also), the playing field is not the same.
But more importantly, Lehman Brothers derives a lot of business from its international clients. 50% of Lehman's revenue in 11/2007 quarter was from outside USA. At the end of the last quarter, Lehman had $629 billion in capital markets, $8.8 billion in investment management and $1.3 billion in investment banking assets. With a $12.4 closing price on 07/14/2008, and almost 694 million floating shares, the 8.4 billion current market value of Lehman is not equal to even its investment assets, let alone the huge $629 billion in capital markets.
And of course, this reflects the effect of mass madness when nobody wants to dig deep and know the truth or believe in it.
Lehman is not going down even after the rampant short selling. So a savvy investor should buy this stock at every downtick created by the short sellers. Returns in few months will again be at least 100-150%.
Disclosure: No positions in FRE, FNM or LEH at the time of writing.