BUS 430 (International Business) - Graded Project - NAKED SHORT SELLING

Graded Project - NAKED SHORT SELLING

Overview

The declining values in Fannie Mae and Freddie Mac stocks in 2007–2008 were the result of risky mortgages and foreclosures. This led to a surplus of declining real property values in the United States and a significantly negative impact on equity prices and FINANCIAL markets in the United States and

around the world. It’s likely that this topic will be studied for many years, as Alan Greenspan, former Federal Reserve Chairman, has referred to it as a once-in-a-century “financial tsunami.”

On the following page are graphic representations of the STOCK price per share for Fannie Mae (FNM) (Figure 1) and Freddie Mac (FRE) (Figure 2), the holders of approximately 50 percent of the mortgages in the United States.

Instructions

Read the boxed article, “Reinflating Real Property Values,” by A. J. Cataldo and Anthony P. Curatola, from Strategic Finance, October 2008. Then respond to the questions that follow. Feel free to use Google, Wikipedia, or any other reliable Internet sources for your research. Be sure to verify your

answers by checking multiple sources.

96 Graded Project

FIGURE 1

FIGURE 2

Graded Project 97

REINFLATING REAL PROPERTY VALUES

By A. J. Cataldo, CMA, CPA, and Anthony P. Curatola

Reprinted with permission from Strategic Finance, October 2008.

On September 8, 2008, Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM), the holders of approximately 50% of mortgages in the United States, were seized by the U.S. government in

a “bailout” that may cost American taxpayers between $100 billion and $300 billion. Effectively, owners of common equity saw the value of their holdings in these two firms decline by 80% to 90% as the common STOCK price per share for Freddie dropped from $5.10 to $0.88 per share and the common stock price per share for Fannie dropped from $7.04 to $0.73 per share.

Because short positions effectively increase the number of shares issued and outstanding, more than 110% of the shares of both Freddie and Fannie were held by institutions. Approximately 50% of the shares of Freddie and Fannie were TRADED on Monday, September 8, 2008, following the news of the seizure over the preceding weekend. While many possible solutions may be under consideration, one possible fiscal policy-based answer may be to simply reduce the depreciable lives for residential real property, effectively increasing the net present value (and, therefore, the value) of these properties, if held for TRADE or business purposes. Some comparison between a less-recent historical crisis and the present situation warrants review.

Change in Fiscal Policy: 1987 Crash

The Economic Recovery Tax Act of 1981 (ERTA81) greatly accelerated the depreciation deductions

available for all asset classes, including real property, under the accelerated cost recovery

system (ACRS).The Tax Reform Act of 1986 (TRA86), passed by Congress on October 22,

1986, provided for an increase in the depreciable lives of real property from their ACRS-based

lives of 15 years to a MACRS-based (modified ACRS) life of 27.5 years (or longer) while

severely restricting passive activity losses (PALs). Approximately one year later, on Monday,

October 19, 1987, the Dow Jones Industrial Average (DJIA) dropped more than 22% in a single

TRADING day. While there’s no denying that program TRADING led the list of contributing variables

to the 1987STOCK MARKET “crash,” another possible causal link is the extension of depreciable

lives—the move from ACRS to MACRS—and the imposition of passive activity loss limitations

(PALs), which together placed downward pressure on real property values as an asset class.

These provisions of TRA86 may have made economic sense on one dimension, but they were

also likely to have contributed to the end of the real estate boom in the early to mid-1980s as

well as to the savings and loan (S&L) “crisis” and the formation of the Resolution Trust

Corporation (RTC) that followed.

(Continued)

98 Graded Project

REINFLATING REAL PROPERTY VALUES—Continued

Change in Monetary Policy: 2008 Crash

The stage was set for the current housing crisis during the 2002 through 2004 period. Many

Americans refinanced their existing home mortgages at lower interest rates, effectively “cashing

in” and consuming much of their equity, but the real problem arose when no-qualifying and

no-documentation (no-doc) mortgages were approved by lenders. In many cases, these were

negative amortization loans for the first few years of the life of the mortgage and/or adjustable

rate mortgages, and, as interest rates recovered (June 2004), payments on these mortgages

were reset at higher interest rates and higher monthly payments. Many new homeowners, as

well as speculators anticipating a continuing rise in real property values, were unable (or

unwilling) to make these higher payments as their equity positions evaporated. Lenders’

declining collateral positions in these real properties, loan defaults, and home foreclosures

grew, increasing the nonperforming components of lender portfolios of home mortgage loans.

The Mortgage Forgiveness Debt Relief (MFDR) Act of 2007 provided some relief to taxpayers.

As real property values declined and mortgages exceeded the fair MARKET value of these

properties, financial institutions holding these nonperforming, or “at risk,” loans experienced

increased shorting and even naked shorting of their equity securities. (“Naked shorting” is the

sale of a stock that you don’t own in anticipation of buying or “covering” this position at a

future date and a lower price for a profit.) The Securities & Exchange Commission, the Federal

Reserve, and the Secretary of the Treasury joined forces to suspend “naked shorting” of

Freddie, Fannie, and 17 other financial institutions, but the suspension was only temporary.

During the early portion of the suspension period (July 11, 2008, through July 23, 2008),

nearly one-third of a trillion dollars of MARKET capitalization recovery occurred for these

financial institutions.

Stabilizing Residential Housing Values and Stimulating Demand

One of many possible solutions might include a reduction in the depreciable lives for residential

housing. Increases in depreciation expense increase the depreciation tax shield, after-tax cash

flow, and net present values for long-lived assets. While this may not solve the problem for

homeowners, the consensus in the business and general press is that home foreclosures and

mortgage defaults combined with the increase of these nonperforming loans in lenders’ portfolios

suggests that many of those approved for these troubled loans simply weren’t economically

able to purchase these homes at the time these mortgages were approved. Therefore, it

appears that an insufficient number of creditworthy homeowners may be available to absorb

the increased inventory of residential housing, and the only alternative may be to provide fiscal

policy-based economic incentives to investors to absorb the surplus supply for the near term.

Perhaps it’s merely a question of the “form” of the bailout: (1) a tax-incentive-based fiscal

policy measure or (2) direct governmental ownership of Fannie and Freddie.

A. J. Cataldo, II, CMA, CPA, Ph.D., is a professor of accounting in the School of Business and

Public Affairs at West Chester University, West Chester, Pa. He can be contacted at

a..o@wcupa.edu. Anthony P. Curatola is the Joseph F. Ford Professor of Accounting at

Drexel University in Philadelphia, Pa. You can reach Tony at (215) 895-1453 or

c..a@drexel.edu. © 2008 A. P. Curatola.

Project Questions

1. Fannie Mae and Freddie Mac are GSEs. Define GSE with a brief explanation. (10%)

2. To slow the decline of MARKET values of Fannie Mae, Freddie Mac, and 17 other FINANCIAL firms, the Securities and Exchange Commission (SEC) suspended naked shorting for a short period.

a. What is a long position in a STOCK? (5%)

b. What is a short position in a STOCK? (5%)

c. What is a naked short position in a STOCK?

(Distinguish between a short and a naked short.) (10%)

d. Are retail investors or TRADERS permitted to naked short a STOCK? (10%)

e. Who is permitted to naked short a stock (assuming there has been no suspension of this practice)? (5%)

3. a. Following the first SEC suspension of naked shorting (post–June 2008), did other nations follow this practice? (5%)

b. If not, explain why. If so, list a few. (5%)

4. When the temporary suspension of naked shorting was imposed by the SEC, STOCK prices increased, due to a “short squeeze.” Explain the term “short squeeze.” (10%)

5. The problems with Fannie Mae, Freddie Mac and other FINANCIAL institutions were said to have been caused by the securitization of risky mortgages issued to uncredit worthy borrowers along with credit default swaps to insure these risky mortgages. The credit default swaps weren’t capitalized—there was nothing available to pay off on these credit default swaps, so when the borrower defaulted on the mortgage and the credit default swap was to be “cashed in,” there was nothing available and

these securitized mortgages became worthless.

100 Graded Project

a. Worldwide, what’s the approximate value of credit default swaps in circulation during this period? (5%)

b. How did this amount compare to U.S. and worldwide gross domestic product (GDP) during this period? (5%)

6. a. In whatCURRENCY is oil TRADED? (5%)

b. In what CURRENCY are credit default swaps traded? (5%)

7. a. Will the U.S. dollar remain the CURRENCY of choice? (5%)

b. Have any nations called for a switch from the U.S. dollar? (10%)

Writing Guidelines

1. Type your submission, double-spaced, in a standard print font, size 12. Use a standard document format with 1-inch margins. (Do not use any fancy or cursive fonts.)

2. Include the following information at the top of your paper:

a. Name and complete mailing address

b. Student number

c. Course title and number (International Business, BUS 430)

d. Project number (50067000)

3. Read the assignment carefully and answer each question. Use proper citation in either APA or MLA style.

4. Be specific. Limit your submission to the questions asked and issues mentioned.

5. Include a reference page in either APA or MLA style. On this page, list Web sites, journals, and all other references used in preparing the submission.

6. Proofread your work carefully. Check for correct spelling, grammar, punctuation, and capitalization.