BUS 430: International Bus Assignment

By A. J. Cataldo, CMA, CPA, and Anthony P. Curatola

Reprinted with permission from Strategic Finance, October 2008.

On September 8, 2008, Freddie Mac (NYSE: FRE) and Fannie Mae (NYSE: FNM), the holders of approximately 50% of mortgages in the United States, were seized by the U.S. government in a “bailout” that may cost American taxpayers between $100 billion and $300 billion. Effectively, owners of common equity saw the value of their holdings in these two firms decline by 80% to 90% as the common stock price per share for Freddie dropped from $5.10 to $0.88 per share and the common stock price per share for Fannie dropped from $7.04 to $0.73 per share. Because short positions effectively increase the number of shares issued and outstanding, more than 110% of the shares of both Freddie and Fannie were held by institutions. Approximately 50% of the shares of Freddie and Fannie were traded on Monday, September 8, 2008, following the news of the seizure over the preceding weekend. While many possible solutions may be under consideration, one possible fiscal policy-based answer may be to simply reduce the depreciable lives for residential real property, effectively increasing the net present value (and, therefore, the value) of these properties, if held for trade or business purposes. Some 
comparison between a less-recent historical crisis and the present situation warrants review.

Change in Fiscal Policy: 1987 Crash

The Economic Recovery Tax Act of 1981 (ERTA81) greatly accelerated the depreciation deductions available for all asset classes, including real property, under the accelerated cost recovery system (ACRS). The Tax Reform Act of 1986 (TRA86), passed by Congress on October 22, 1986, provided for an increase in the depreciable lives of real property from their ACRS-based lives of 15 years to a MACRS-based (modified ACRS) life of 27.5 years (or longer) while severely restricting passive activity losses (PALs). Approximately one year later, on Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) dropped more than 22% in a single trading day. While there's no denying that program trading led the list of contributing variables to the 1987 stock market “crash,” another possible causal link is the extension of depreciable lives—the move from ACRS to MACRS—and the imposition of passive activity loss limitations (PALs), which together placed downward pressure on real roperty values as an asset class.

These provisions of TRA86 may have made economic sense on one dimension, but they were also likely to have contributed to the end of the real estate boom in the early to mid-1980s as well as to the savings and loan (S&L) “crisis” and the formation of the Resolution Trust.