Securities treated differently for fear rules will change

By DAVID MOON, Moon Capital Management, LLC
February 21, 2010


Imagine you are playing a game of competitive golf with a fierce rival with a large bet riding on the outcome. There is one strange twist in this round, however. At any time the club pro can change the rules. He might add two strokes to your score for sinking a long putt. He might deduct a stroke or three from your rival’s scorecard for losing his ball in the woods. At any time he might scream and tackle you in the middle of your swing.

It would affect your game a bit, I suspect. You might even choose not to play under such conditions.

The equivalent of that situation exists on Wall Street today.

In an apparent case of market inefficiency, investors and rating agencies are treating very similar securities differently, fearful that the government might change the rules in the middle of the game.

Following the bailout of the Federal National Mortgage Association (FNMA), the federal government now owns 79.9 percent of the company. A FNMA bond maturing on March 15, 2011 currently yields 0.36 percent.

Technically, in order for FNMA to default on this bond, the US government would first have to lose its equity investment in the company. Those are the business rules in the US. Bondholders get their money back before the stockholders do The US government has invested $111 billion in FNMA.

The federal government also owns 79.9 percent of financial conglomerate AIG, but the market perceives the default risk on these bonds to be astronomically higher. A March 15, 2011 AIG bonds currently yield 11.02 percent, almost eleven percentage points more than the FNMA bond with the same maturity.

The Federal Reserve and Treasury made over $182 billion available to assist AIG. As president of the Federal Reserve Bank of New York in 2008, current Treasury Secretary Timothy Geithner was one of the original architects of the scheme to save AIG, arguing that its demise would cause “catastrophic damage to the economy.”

If the federal government is the controlling shareholder and one of the largest creditors of both FNMA and AIG, why is there such a discrepancy in the yields of their bonds?

Because investors are concerned about the prospect of the rules of business being unequally applied, based on the political popularity of a company or its executives.

FNMA is considered politically safe. Homeownership is like apple pie. AIG is in the financial services area, an industry competing with drug dealers and Lane Kiffin for losers in the popularity contest.

The law doesn’t differentiate between saints and snakes. But tell that to the GM bondholders. And the shareholders at Bear Stearns. And the banks that were forced to take TARP funds so there would be no stigma attached to the companies who actually needed it.

In each of those cases, the rules of the game were changed in the middle of the game. That’s why investors are leery of the same thing happening at AIG.

There are plenty of unknowns in any investment decision. But there are supposed to be some knowns. One of them is the sanctity of contract law.


David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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