I am pleased to report I ran the 5 km race this weekend in 30:31 (or a little under 10:00 a mile). Given my year end goal is a 9 minute miles, I am making some real progress. Given this was my first race ever, I was also astonished to see first hand some professional racers finishing a half marathon in 50 minutes. Just jaw-dropping.

It seems like years ago the first shoe of the sub-prime mortgage/real estate collapse dropped with Bear Stearns selling itself at a massive discount as a way to get out of all the bad mortgage backed corporate paper they bought. This only happened in March. Now, it seems like the other shoe is falling with: (i) stories about Freddie Mac and Fannie Mae both being in financial trouble; (ii) The government stepping in and taking over IndyMac Bancorp, a California based bank worth an estimated $32 billion, due to a massive withdrawals of money by customers started by rumors the bank had too many bad mortgages on the books and would collapse (well, I did predict a mid-tier bank would go down in the 2nd half of 2008); and (iii) the Government of Canada changing the mortgage rules to eliminate the 40 year mortgage and the zero-down mortgage to prevent an American style real estate bubble (although some argue that the horse is out of the barn already). All this happened in 5 days. Wow.

The Freddie Mac/Fannie Mae rumors are the particularly frightening ones. Remember that Bear Stearns was solvent when it was sold; Bear Sterns could not over-come the market panic, short-term cash crunch and a lack of a short-term lender to bail them out which lead to their demise. It almost appears, to quote Yogi Berra, its deja vu all over again as we are seeing Bear Stearns part II. Freddie and Fannie buy mortgages off the banks so that banks can lend out more mortgages because they are not on their balance sheet; without them, the mortgage market would be considerably smaller and many people would not qualify for a mortgage. There’s really two things that can happen in this climate: (i) do nothing and hope the market comes to their senses; or (ii) government bail-out. Option (i) is not plausible in an election year (this post was written before the Feds announced Sunday night it would take steps to prop up Freddie and Fannie).

So what are we to make of these three events if we connect the dots.

1. Only a pollyanna would believe we are not in trouble in the short-term. It takes years for a traumatic effect like the subprime/real estate collapse to work its way through the system. Unlike the tech crash, where the damage was confined to day-traders, a real estate collapse and a banking crisis affects everyone on a day to day basis. Governments hate make it harder for the voters to do or get anything so you know that the Canadian government is worried if they are making it harder for us to get a mortgage; although the spin was very effective, a minority government changing the rules to make it harder to get something shows you how serious the issue is since this should be against every political instinct of a government seeking majority status. But, before you head to your nuclear bomb shelters, remember that unemployment is still in the mid-single digits (in the 1991 recession, it pushed 12%); it will work itself out but let’s not kid ourselves that it will happen in days or weeks.
2. Who exactly can you believe? IndyMac had to be taken over by the government because of a statement a Senator made about its financial condition which may or may not be true. Freddie/Fannie fall under the same category. Are banks taking successive write-downs so that a write-off will be smaller (a write-down is you write off a portion of the loan as recoverable; a write-off is you write the entire thing off as unrecoverable but if write-down a loan multiple times- and the banks don’t tell you which loan they are writing down- suddenly a final write-off doesn’t look that bad)? Disclosure is becoming a key factor in all financial stocks going forward.
3. The recovery will be long (but, there will be a recovery). Let’s assume either for financial stability or perception, the government steps in and props up Freddie/Fannie with an low-interest loan, equity infusion or plain just takes it over. Where do you think its going to get this money from? It has one of two choices: (i) it can raise taxes to get the revenue for this bail-out- absolute political suicide in an election year so not very plausible; or (ii) run up the deficit some more- what’s a couple hundred billion more to a trillion dollar American deficit? What happens to a country where the government is running up a massive deficit and debt? It re-directs money that would otherwise be lent to business to create jobs, buy equipment and expansion to government debt financing which makes the economy less effective and impedes economic growth (it is no coincidence that the economic expansion of the 1990′s occurred in a no government deficit era). I fully expect the recovery to be long and growth modest. For demographic and geo-political reasons, we probably won’t see another go-go period like the rise of tech and real estate again.

From a philosophical level, this is all well and go but what about us?

1.  As a bank stock junkie, I am not touching a bank stock for a while. There are some real hard questions bankers have to start answering about the strength of their balance sheet; their words and actions do not align. TD Bank, which is one of the 10 largest retail banks in North America, did not buy any subprime mortgage commercial paper but it, like its other counterparts, keeps issuing more preference shares- the latest being on a $250 million raise on July 7. Why? I hope it is to raise money to buy assets but I also worry its being used to prop up balance sheets.
2. The smaller the bank, the more I would worry. IndyMac ran into an issue in that its assets were too small to really pursue an equity raise. Earlier this month, another regional bank, Zions Bancorp, disclosed it only raised $45.7 million of an expected $150 million equity raise; there is a real chill in the market for raising money for smaller banks.  While big and small banks alike have the same issue, a big bank at least has the assets to leverage to prop up their balance sheets or sell off divisions for cash. As much as I am not buying a bank now, banks will eventually recover and these recent events show big banks provide some degree of shelter.
3. In the long term, this is a good thing if you are entering the real estate market soon. This is a very painful removal of the rampant speculation of real estate which lead to unrealistic valuations and the creation of financial vehicles to feed the beast. Think about the last 5 years this way; you want to sell your car and the person wanting to buy it from you has dodgy credit, wants you to loan them the money with no money down and is willing to pay 20% more than you offered; wouldn’t you question the sanity of this person (not to mention wonder if you were ever going to be paid back on the car) and reject the offer? Strangely, no one batted an eye when this occurred with real estate.  First-time and young home-buyers may actually be able to buy starter-homes again. As for the removal of the no-money down mortgages- good. Home ownership is not a right (the constitutional right to property is a right against unlawful seizure by government not a right to own a house). It will encourage savings which is not a bad thing.

As for the question of “what do I do now?” How about nothing? Remember the 80-20 rule (the Pareto Principle)- 80% of the effects (your results) are from 20% of the causes (your effort). You don’t have to be in constant motion in reaction to some event. Stay in cash. Manage your budge properly. Enjoy the summer. We’ve muddled through hundreds of years of doomsayers writing about imminent economic disaster and yet we survive.