BUS 430: International Bus Assignment (Coursework Sample)
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 1987 stock 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 roperty 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.
International Bus Assignment
Name and complete mailing address
Course title and number (International Business, BUS 430)
1. Fannie Mae and Freddie Mac are GSEs. Define GSE with a brief explanation. (10%)
Government-sponsored enterprise (GSEs) are federally chartered financial institutions necessary to facilitate the flow of investment funds on favorable terms to higher education, agriculture, and housing, including the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
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?
A long position of stocks means that the investor purchases and owns the stocks that they choose to trade and they trade the stock based on the assumption that the security will rise in value.
b. What is a short position in a stock?
A short position in a stock means that an investor owns the stocks or other securities to someone else as they do not own them yet, but they can sell the borrowed securities in anticipation that the price will drop and they will profit and purchase at lower prices (SEC, 2015).
c. What is a naked short position in a stock? (Distinguish between a short and a naked short.)
The naked short position in a stock is short selling a stock without borrowing or owning shares and this sometimes occurs when it is difficult to borrow these shares, but this is mostly associated with questionable and even illegal activities (SEC, 2015). Naked short selling of Fannie Mae and Freddie Mac shares during the 2007-2009 financial crisis left investors vulnerable (Cataldo, 2008). On the other hand, short selling involves trading the stocks that have been borrowed mostly from brokerage firms where it is still assumed that the price will fall, but active short selling meant to depress prices is illegal. When demand exceeds supply and there is a restriction on what insiders can sell there is the likelihood of shorting the shares. SHO regulations address failures to deliver securities within their standard 3-day settlement period to eliminate the abusive naked short selling practices (Gregoriou, 2012)
d. Are retail investors or traders permitted to naked short a stock?
Naked short selling of stocks is not permitted to retail investors and traders, but they may borrow from approved intermediaries and even as there are no honoring obligations and delivering securities like short selling. Nonetheless, there are more regulations governing naked short selling and yet retail investors are necessary to keep the market active and even maintaining liquidity. For instance, the brokers and dealers buy and sell the securities regally and continuously and mostly sell when there are temporary shortages (SEC, 2015).
e. Who is permitted to naked short a stock (assuming there has been no suspension of this practice)? (5%)
The Securities and Exchange Commission identifies broker-dealers as the parties ready to naked short stocks as they are maker makers who are ready to deal in different...
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