Agency Costs In Mortgages

One of the factors blamed for the meltdown in the real estate market in 2007 and 2008 was agency costs. Prior to that period, banks and other mortgage issuers would issue a mortgage to an individual, then immediately sell the entire mortgage to a company that would package mortgages and sell mortgage backed securities (MBSs) to bondholders. The agency costs arose because the mortgage and MBS issuers had no "skin in the game," meaning that if the borrower defaulted, the they did not take a loss. As a result, some mortgage issuers issued mortgages to anyone with a pulse since the issuer would not take a loss if the borrower defaulted.

Due to this agency cost, regulations were put in place to require mortgage and MBS issuers maintain skin in the game, meaning that if the borrower defaulted, the mortgage and MBS issuers would both share in the loss with bondholders. Six U.S. regulatory agencies have proposed that the regulations be loosened to allow banks and MBS issuers to reduce their exposure to mortgages that meet less stringent requirements. Under the new proposal, mortgages that meet a minimum standard from the U.S. Consumer Financial Protection Bureau will not require banks and MBS issuers to retain interest in the mortgage.

S&P 500 PE Rises

According to a recent report, the PE ratio of the S&P 500 has risen to 16, a 14 percent increase relative to earnings over the last 12 months. The last time the PE ratio has risen this fast was 1999, just prior to the dot com crash. The S&P 500 PE has averaged 17.4 during bull markets since 1957, and have typically reached a high of 20.2 at the top of the market, with a high of 31 times  in March 2000.

Microsoft Management

So what happens when a CEO leaves unexpectedly? If the stock market feels that the CEO is effective, the stock price should drop. Evidently, stock market participants felt that Microsoft CEO Steve Ballmer wasn't doing a very good job: Microsoft stock jumped 8 percent in pre-market trading on the news that Ballmer would retire in the next 12 months. In a strange twist, Ballmer's net worth jumped about $1 billion on the stock price increase because of the the number of Microsoft shares he owns.

100-Year Bonds Take A Hit

Since 1993, 65 100-year bond issues have occurred in the U.S, with a face value of $16.29 billion. Of course, since long-term bonds have more interest rate risk than short-term bonds, you would expect these bonds to have lost significant value in recent months, and you would be correct. For example, IBM's 100-year bonds have dropped 18 percent since May and MIT's 100-year bonds have dropped 19.3 percent with only a one percent increase in YTM.

Technical Analysis And The Hindenburg

It appears that the Hindenburg Omen has reared its ugly head. The Hindenburg Omen is a collection of four criteria that, when they occur simultaneously, is used to predict a stock market crash. Technical analysts who believe in the Hindenburg Omen argue that if it occurs twice in a 30-day period, the market is primed for a meltdown. Of course, as with many technical indicators, there is some confusion about how to read the tea leaves. For example, some technical analysts argue that a 36-day period should be used, others argue for 30 calendar days, and others use 30 trading days. And as with many other technical indicators, believers discuss the instances it has worked, such as the 2007 market crash and 2000 tech bubble, and conveniently ignore the times when the Hindenburg Omen was wrong.

Uninformed Investors

One of the key factors that we use to decide if we would choose a particular investment is if we understand the particular investment and its risks. A recent survey by brokerage Edward Jones indicates that many investors don't agree with this strategy. Due to recent Federal Reserve actions, interest rates have begun to rise, which you should now be aware causes a decrease in bond prices. However, in the survey, 63 percent of investors didn't know that rising interest rates would impact 401(k)s, IRAs, and other investment portfolios. Further, one-third of investors between 18 and 34 had no idea how interest rates impact a portfolio, and 25 percent of investors over 65 had no idea of the impact of interest rates.

"Happy Meal" Bonds

Cash strapped companies who would typically find a bond issue problematic are turning to "Happy Meal" bonds. With a Happy Meal bond issue, the company issues convertible bonds and simultaneously lends the bond purchaser shares of stock. The bond purchaser will typically short sell the stock. In case you aren't familiar with a short sale, an investor sells borrowed stock today and later buys the stock back and repays the borrowed shares. Therefore, a short sales results in a profit when the stock price drops. Happy Meal bonds are typically purchased by hedge funds. So far, 19 of 24 companies who issued Happy Meal bonds have experienced a stock price decline in the 200 days after the bonds issue, with an average price drop of 53 percent. Proponents of Happy Meal bonds argue that the type of company that is forced to raise capital with a Happy Meal issue is more likely to experience financial difficulty.