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Graded ProjectNAKED SHORT SELLINGOverviewThe decli...




Graded ProjectNAKED SHORT SELLINGOverviewThe declining values in Fannie Mae and Freddie Mac stocksin 2007–2008 were the result of risky mortgages and foreclosures.This led to a surplus of declining real property valuesin the United States and a significantly negative impact onequity prices and financial markets in the United States andaround the world. It’s likely that this topic will be studiedfor many years, as Alan Greenspan, former Federal ReserveChairman, has referred to it as a once-in-a-century “financialtsunami.”On the following page are graphic representations of the stockprice per share for Fannie Mae (FNM) (Figure 1) and FreddieMac (FRE) (Figure 2), the holders of approximately 50 percentof the mortgages in the United States.InstructionsRead the boxed article, “Reinflating Real Property Values,”by A. J. Cataldo and Anthony P. Curatola, from StrategicFinance, October 2008. Then respond to the questions thatfollow. Feel free to use Google, Wikipedia, or any other reliableInternet sources for your research. Be sure to verify youranswers by checking multiple sources.Grraaddeedd PPrroojjeecctt96 Graded ProjectFIGURE 1FIGURE 2Graded Project 97REINFLATING REAL PROPERTY VALUESBy A. J. Cataldo, CMA, CPA, and Anthony P. CuratolaReprinted with permission from Strategic Finance, October 2008.On September 8, 2008, Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM), the holders ofapproximately 50% of mortgages in the United States, were seized by the U.S. government ina “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% to90% as the common stock price per share for Freddie dropped from $5.10 to $0.88 per shareand 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, morethan 110% of the shares of both Freddie and Fannie were held by institutions. Approximately50% of the shares of Freddie and Fannie were traded on Monday, September 8, 2008, followingthe news of the seizure over the preceding weekend. While many possible solutions may beunder consideration, one possible fiscal policy-based answer may be to simply reduce thedepreciable 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. Somecomparison between a less-recent historical crisis and the present situation warrants review.Change in Fiscal Policy: 1987 CrashThe Economic Recovery Tax Act of 1981 (ERTA81) greatly accelerated the depreciation deductionsavailable for all asset classes, including real property, under the accelerated cost recoverysystem (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-basedlives of 15 years to a MACRS-based (modified ACRS) life of 27.5 years (or longer) whileseverely 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 singletrading day. While there’s no denying that program trading led the list of contributing variablesto the 1987 stock market “crash,” another possible causal link is the extension of depreciablelives—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 werealso likely to have contributed to the end of the real estate boom in the early to mid-1980s aswell as to the savings and loan (S&L) “crisis” and the formation of the Resolution TrustCorporation (RTC) that followed.(Continued)98 Graded ProjectREINFLATING REAL PROPERTY VALUES—ContinuedChange in Monetary Policy: 2008 CrashThe stage was set for the current housing crisis during the 2002 through 2004 period. ManyAmericans refinanced their existing home mortgages at lower interest rates, effectively “cashingin” and consuming much of their equity, but the real problem arose when no-qualifying andno-documentation (no-doc) mortgages were approved by lenders. In many cases, these werenegative amortization loans for the first few years of the life of the mortgage and/or adjustablerate mortgages, and, as interest rates recovered (June 2004), payments on these mortgageswere reset at higher interest rates and higher monthly payments. Many new homeowners, aswell as speculators anticipating a continuing rise in real property values, were unable (orunwilling) to make these higher payments as their equity positions evaporated. Lenders’declining collateral positions in these real properties, loan defaults, and home foreclosuresgrew, 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 theseproperties, financial institutions holding these nonperforming, or “at risk,” loans experiencedincreased shorting and even naked shorting of their equity securities. (“Naked shorting” is thesale of a stock that you don’t own in anticipation of buying or “covering” this position at afuture date and a lower price for a profit.) The Securities & Exchange Commission, the FederalReserve, and the Secretary of the Treasury joined forces to suspend “naked shorting” ofFreddie, 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 thesefinancial institutions.Stabilizing Residential Housing Values and Stimulating DemandOne of many possible solutions might include a reduction in the depreciable lives for residentialhousing. Increases in depreciation expense increase the depreciation tax shield, after-tax cashflow, and net present values for long-lived assets. While this may not solve the problem forhomeowners, the consensus in the business and general press is that home foreclosures andmortgage defaults combined with the increase of these nonperforming loans in lenders’ portfoliossuggests that many of those approved for these troubled loans simply weren’t economicallyable to purchase these homes at the time these mortgages were approved. Therefore, itappears that an insufficient number of creditworthy homeowners may be available to absorbthe increased inventory of residential housing, and the only alternative may be to provide fiscalpolicy-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 fiscalpolicy 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 andPublic Affairs at West Chester University, West Chester, Pa. He can be contacted Anthony P. Curatola is the Joseph F. Ford Professor of Accounting atDrexel University in Philadelphia, Pa. You can reach Tony at (215) 895-1453 © 2008 A. P. Curatola.Graded Project 99Project Questions1. Fannie Mae and Freddie Mac are GSEs. Define GSE witha brief explanation. (10%)2. To slow the decline of market values of Fannie Mae,Freddie Mac, and 17 other financial firms, the Securitiesand Exchange Commission (SEC) suspended nakedshorting 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 nakedshort a stock? (10%)e. Who is permitted to naked short a stock (assumingthere 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 wasimposed 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 otherfinancial institutions were said to have been caused bythe securitization of risky mortgages issued to uncreditworthyborrowers along with credit default swaps toinsure these risky mortgages. The credit default swapsweren’t capitalized—there was nothing available to payoff on these credit default swaps, so when the borrowerdefaulted on the mortgage and the credit default swapwas to be “cashed in,” there was nothing available andthese securitized mortgages became worthless.100 Graded Projecta. Worldwide, what’s the approximate value of creditdefault swaps in circulation during this period? (5%)b. How did this amount compare to U.S. and worldwidegross domestic product (GDP) during this period? (5%)6. a. In what currency 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%)


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