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The Sinister Story Behind Fannie and Freddie

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The Sinister Story Behind Fannie and Freddie

Post by Sean on Wed Sep 10, 2008 8:52 am

The Sinister Story Behind the
Freddie and Fannie Bailout

Good day... And a Terrific day to you! Very Happy

The stock market here in the U.S. sure liked the news about Fannie and Freddie! Laughing

I guess stock traders didn't get the memo that another government-sponsored bailout will put billions of dollars of tax burden on taxpayers. It will also most likely cause a major disruption in the Credit Default Swaps (CDS) that are still on banking books. affraid

Oh, well, we have to learn to deal with mental giants all our lives. This is just another example! pig

So, first, I want to tell you how this epic bailout affected currencies. Then I'd like to take you for a ride on the CDS liquidation wagon. Let me warn you upfront: It's not a particularly pretty or scenic ride, but it's definitely worth taking. rendeer

First off, the Fannie and Freddie news caused the dollar bulls to shake the euro to its foundation yesterday and the euro sank even further. In fact, at one point the euro looked liked it might fall below US$1.40. For the euro (and other currencies), selling came swift and harsh, right after the stock market opening bell. However, the good news is the euro has rebounded in the overnight markets of Asia and Europe to 1.4175... geek

Traders didn't have any data or news from overseas yesterday morning to warrant the stock market rally. No sir - it was just plain and simple stock market euphoria here in the U.S. lol!

Plus, foreigners wanted in on the "action," so they also started scooping up U.S. stocks. When foreigners buy U.S. stocks, they have to exchange their currency for the dollar, and that pushes the dollar higher. cheers

But, as I said, the currencies have rallied back overnight, so, as long as yesterday's selling is water under the bridge, I'll be okay with that! alien


A Ride on the CDS Wagon
Let's get to this credit default swaps (CDS) stuff, because this is important. There will be a meeting today to discuss how this will all play out. But here's some perspective on the situation...

First and foremost, there's a question as to whether the government's recent bailout constitutes a "CDS event." If it is a "CDS event," it could force financial institutions to settle outstanding CDS contracts.

Fannie and Freddie have roughly US$1.5 Trillion in outstanding debt. But that's chickenfeed compared to what institutions have in CDS contracts. In fact, we could see multiples of that US$1.5 Trillion worth of unsettled debt!

If Uncle Sam's Freddie and Fannie bailout does constitute a "CDS event" there won't be enough debt to settle the contracts. This will lead to a need for cash. And that could lead to major problems. The least of these problems will be holders who need the cash might have to sell other assets to raise the capital they need.

I know this can be confusing. Honestly, it took me a while to fully understand these credit default swaps. But in essence CDS are simply insurance policies. Debt holders can use them to hedge, or insure against a default under the debt instrument. In case you're wondering, yes, CDS's fall under the heading of "derivatives" that you've heard all about.

Sean

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The Market of Last Resort:Where to Turn When the Markets Turn Against You

Post by Sean on Sun Sep 14, 2008 3:36 pm

I'm sure I don't have to tell you the traditional stock and commodity markets have been absolutely slaughtered in the last few months. pale

In fact, all you have to do is check out the chart of the Dow Jones Industrial Average or the S&P 500 to see which direction they've been heading. Or take a look at an oil chart or a chart of gold and you will see the exact same thing. As I said yesterday, that's because right now we're stuck in the middle of the economic cycle where both stocks and commodities suffer. affraid

However there is a piece of good news hidden beneath all this market misery...in the currency markets. Certain currencies have continued to rise right through the worst of the recent pullbacks in stocks and commodities.

This is not unusual. Several currencies have a reverse correlation to the overall markets. In other words, these currencies tend to rise when the greater markets drop. Two such currencies are the Japanese yen and the Swiss franc.

Let me explain why these two currencies are prospering...

A Currency for Every Market
Remember, yesterday I mentioned that a few currencies perform well during the "recovery" phase in the economic cycle. These are usually the currencies with expanding economies (i.e. rising inflation and rising interest rates). afro

On the other hand, there are the currencies that prosper during tough times, even during recessions and depressions. These "recessionary" currencies are beaten down during recovery periods. These currencies also tend to have lower interest rates, so they give a lower yield.

Traders scorn these currencies when other markets are soaring because no one wants their "paltry interest" and smaller growth, when they can get higher returns elsewhere.

However, when markets start to fall, currency traders grab these currencies with both hands to save their portfolios.

To recap: During stock bull markets, currency investors are busy buying up high-yielding currencies and continually selling low interest yielding currencies. But when bad times hit, currency investors quickly trade in their high-yielding currencies for the safety of the ‘beaten-down dog' currencies like the Japanese yen and Swiss franc.

Just to show you how powerful these low-yielding currencies can be, let me show you a chart of the Japanese yen vs. the S&P 500. As you'll see, the yen is rising as stocks are falling. The opposite is also true. When the line on the chart is falling, the yen is falling as stocks are rising once again.

As Stocks Head South, the Japanese Yen & Swiss Franc Head North!

[You must be registered and logged in to see this image.]
In the three year chart above, you can see the yen dropped in 2006 and much of 2007, as stocks rose. But as the sub-prime mortgage problems erupted into the market in July 2007, the yen bottomed against stocks and started to head higher, while stocks plummeted.

Notice the HUGE run-up of the yen as stocks started to fall. Now that's what I call "growth mode." Yes, you could have grabbed some serious yen profits if you ditched stocks for the "new growth vehicle" - the Japanese yen.

Now, guess what? When the worst of the sub-prime mess finally passes, you'll see the yen start to retreat once again just like they did on the chart in 2006 and earlier 2007.


The Moral of This Story
You have many more investment choices than JUST stocks, bonds and commodities during bear markets. These are all great financial instruments at the right part of the business cycle. But don't forget that the currency markets are all relative, so if one currency is falling in value then there's another one on the rise. These defensive currencies can buffer your portfolios when your stocks come crashing down.

A good tip: Many investors have trouble gauging exactly where we are in the economic cycle. So to reduce confusion, you can place defensive currency plays into your long-term investment portfolio. Then simply hold onto these plays during both recession and recovery periods, so your portfolio is protected no matter what.

This way, when your neighbors are crying over their stock losses or just treading water with their bonds, your portfolio will keep profiting right through the tougher times of the economic cycle.

Sean

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