IVC MORTGAGE STOCKS

The Story of the Times

IVC Mortgage traces the path to and journey through the Financial Crisis of 2008, when the domestic housing bubble burst and brought the international financial markets to its knees. The four instruments available to trade are BAC, FNMA, GS, and XLF. Countrywide Financial, Bear Stearns, and Lehman Brothers would have been interesting additions to the game, but they did not survive the meltdown. The story of the stocks and the story of the times is a cautionary tale.

The game begins in 1999 just before the Dot Com boom. The prime interest rate is 8%. According to census.gov, the average cost of a house in the United States in 1999 is $153,100. The Nasdaq is trading at $2,500 in January 1999, peaks later in the year at $3,940, and ultimately falls to a low of $1,320 by 2002. In a bid to jumpstart a crippled economy, the Fed lowers the prime interest rate to 4%+ at the end of 2001, setting the stage for the Mortgage Bubble and the Financial Crisis of 2008.

Bethany MacLean and Joe Nocera offer a detailed history of events in their book, All the Devils Are Here: The Hidden History of the Financial Crisis. Following the Dot Com crash, requirements for obtaining mortgage loans became more relaxed than ever before, and the housing market and mortgage industry heated up quickly. Countrywide Financial aggressively marketed "No Doc" subprime loans, low introductory rates, and interest only payment schedules. People refinanced houses to extract large amounts of equity and buy expensive houses beyond their means with the belief that housing prices would continue to climb, allowing them to "flip" their investment within a year and make a handsome profit.

A robust secondary market allowed mortgage loan originators to sell the loans, effectively shielding the originators from the risk of default. Fannie Mae, Freddie Mac, and private investment banks issued Mortgage Backed Securities (MBSs), an asset backed security guaranteed by a bundle of mortgages, which were a very popular holding for pensions, mutual funds, hedge funds, and large financial institutions. However, the MBS credit-worthiness rating system was tainted because loan originators were rating the credit-worthiness of the mortgages they sought to sell in order to secure funding for making more deals.

On March 16, 2008 Bear Stearns became the first large institutional victim of the emerging Financial Crisis, when its severe cash flow issues forced them into the arms of JP Morgan Chase at a fire sale price. In September 2008 Lehman Brothers, the fourth largest investment in the US and a huge player in the international bond market, could not meet payment obligations to bondholders. They were forced to declare bankruptcy when neither the other large financial institutions nor the Federal Government would step in to provide a lifeline.

World markets plummeted, and the Federal Government had to step in to restore calm in the markets by promising to bailout the financial industry. This game is the story of those times.

The Story of the Stocks

BAC: Bank of America
BAC is one of the largest commercial banks in the world. John Maxfield of Motley Fool describes the trials they encountered during and after the Financial Crisis. Up until 2005, BAC provided a stable portfolio of diversified financial services to small and large customers, when they decided to buy credit card giant MNBA. Because the credit card industry was plagued by the same credit worthiness issues which came back to haunt the mortgage industry, BAC was forced to write off $79 billion in bad credit card loans between 2008 and 2010.

In 2008, BAC acquired Countrywide Financial, the largest purveyor of residential home mortgages in the US, a blunder of epic proportions. The result was “years of costly litigation, substantial loan losses, and a bloated expense base.” BAC “incurred $91.2 billion worth of legal fines and settlements since the beginning of 2008, most of which relate to mortgages.” BAC stock topped at $53.85 in November 2006 and fell to $.32 by the end of 2008.

FNMA: Fannie Mae
Fannie Mae was established as a federal government agency in 1938, "with a mandate to act as a secondary mortgage market facility that could purchase, hold, and sell FHA-insured loans...providing lenders with cash to fund new home loans”, according to the Federal Housing Finance Authority (FHFA). In the 1960s Fannie Mae was spun off from the Federal Governments and became a publicly traded corporation. Shareholder obligations clashed with the post-Dot Com push by US Government to make housing affordable to a much wider swath of the population. The result was that Fannie Mae guaranteed and bought mortgage loans in the secondary market which were compromised by unqualified buyers.

Everything worked just fine as long as housing prices continued to climb. Distressed homeowners could quickly sell their homes and easily rid themselves of monthly mortgage obligations. When the bottom fell out of the housing market, however, unqualified buyers who were folding under the weight of their monthly obligations began to default on mortgage payments en masse. FNMA stock reached $65.33 in March 2007 but fell to under a dollar by June 2008.  "In July 2008, FHFA placed Fannie Mae and Freddie Mac into conservatorships, where they remain today."

GS: Goldman Sachs
GS, one of the premier international investment banks, weathered the storm relatively well, especially compared to their investment banking peers. GS was placed large volumes of tainted MBSs with their large institutional clients while simultaneously doing credit default swaps that allowed them to effectively bet against those same securities. While this practice was duplicitous, they were never successfully sanctioned for their behavior. The stock price of GS dropped from an August 2007 high of $247 to an October 2008 low of $78, but they stayed in business. Bear Sterns, Lehmann Brothers, and Countrywide Financial were not so fortunate.

As an interesting side note, Hank Paulson, the former CEO of GS, was chosen by President Bush to be the Secretary of the Treasury in 2006 and thus became the architect and public face of the government sponsored mortgage bailout. He brought needed credibility to the administration and helped steer the nation through the early days of the storm. Since 2013, GS has traded in the $150 - $200 range.

XLF: FInancial Select Sector Spyder Fund
XLF tracks an index of S&P 500 financial stocks, weighted by market capitalization, offering exposure to the large institutions in the US Financials sector. For example, as of 2016, top holdings included Berkshire Hathaway, JP Morgan Chase, Citigroup, Bank of America, and Wells Fargo. After several years trading in the $20+ range, XLF ran up above $30 in September 2005, ultimately peaking at a pre-crisis high of $37.90 in April 2007. By February 2009, the price had fallen to $7.60. XLF recovered to trade in the $20s by 2014, but has never returned to the previous highs. Since 2013 the stock has traded in the $18 to $25 range. XLF pays a dividend of 2%, so an investment made in 2000 at $20 per share would at least have returned 2% despite the wild price swings of the ETF itself.


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