The fate of Freddie Mac (NYSE:FRE) and Fannie Mae (NYSE:FNM) hang in the balance.

Some observers think that the Treasury will act before the week is out. I’m not so sure. Freddie was able to float $2 billion worth of bonds at decent interest rates yesterday. It probably bought the F&F flim-flam twins some time.

I don’t know how much time. The market hates uncertainty. And this administration is very good at listening to Wall Street’s concerns. Too good, I believe. Why not listen to Main Street for a change?

Most of you thought Freddie and Fannie should survive – but with additional government safeguards or as small pieces sold to the private sector. I love to hear from insiders – people who worked in the mortgage business. So let’s hear from Richard M. first. He was in the thick of the real estate market when all those sub-prime loans were being made. But he says we should look elsewhere for the housing market’s fall from grace.

I read your article on Fannie & Freddie, most of it I agreed with. However when you say most of the home owners that are in foreclosure should not have owned homes I don’t agree with you for the following reason: I was in the mortgage business and I have processed hundreds of loans from sub-prime 500 FICO scores to A Loans 700 FICO scores and above. I did fixed loans, interest only loans, pay option loans, adjustable loans, stated income stated asset loans (these loans had to produce 12 to 24 months of bank statements to prove they could service the loan) All of the loans that I did were refinances of existing homes. I did not do any financing for purchases.

This is where I believe the market got into trouble, is with home purchases and the people that were buying called SPECULATORS! I read that someone had calculated that more than 25 percent of all homes sold were sold to SPECULATORS and these are the people that caused the market to collapse! Why? The only reason they purchased the homes was to flip them within a year or two and when the market began to turn they just walked away from the homes. I saw this happen to a builder in San Diego, CA. He had all of his luxury homes pre-sold around 120 and when the market begin to tank he found out that all of the people that had put deposits (purchase contracts) on the homes walked, as they were all SPECULATORS!

Very interesting point of view, Richard. You don’t say so specifically, but I take it that your refinancing loans for the most part didn’t get into trouble.

Those speculators that you’re calling out? They were the happy recipients of “Alt-A” loans – which often didn’t require proof of income and other terms typical of prime loans. You probably know that these loans are now affectionately called “liar’s loans.” And a lot more of these kinds of loans (about $950 billion) were made than subprime loans ($650 billion).

You’re right, Richard. We shouldn’t forget about the speculators. They took a festering situation and turned it into a rotten mess.

Let’s hear from another person with a first-hand account of how greed and opportunism took over the mortgage business. Ted S., the floor is yours:

I completely agree with you about the break up of F&F. I had a very successful career in the mortgage business as a loan officer, sales manager of 75 loan officers, underwriter, and underwriting manager before opening my own brokerage and doing very well.

The quality of the loans was pretty good through 2003 and into early 2004. Since that point, everything became in stated income as the banks realized they didn’t want to know what they already knew – people can’t really afford these loans. Best thing to do is don’t ask for income verification…

Those in charge knew exactly what was happening. Even “scoundrel” loan officers (former cell phone kiosk employees who dabbled in the drug trade on the side – were everywhere in Southern California) who’d rip off their own mothers for a $15,000 commission, knew people couldn’t afford the loans.

F&F shouldn’t be saved because they allowed this, along with the banks. They dug their own grave. Every person within the banks that I spoke with knew that people didn’t really make what we had put on the application. They even told us in most cases to “re-submit the application and increase their income to $9,000/mo (on a bank teller for example) and call them a bank manager.”

Best solution, break them up into many parts the way Standard Oil was broken up.

I always suspected Southern California was like that, Ted. It really reminds me of the Enron debacle. All the law firms, accounting firms, investment firms – and everybody else – working with Enron was in on the deceit and rampaging dishonesty. In hindsight, you ask: “How could they?” But at the time, naked greed took over.

Speaking of “how could they?” that is exactly what Kurt S. asks of me.

I agree with your article and that this is a mess created by the greatest group of screw-ups in our country- Congress. However, I have a mutt named Bailey and I think you do a disservice to him comparing Fannie and Freddie to him and all other mutts. My dog is great. Compare F and F to Congress and that would be a true insult and would not demean dogs like mine. Thanks and keep writing the good stuff.

I’m sorry, Kurt. I have two dogs of my own. They’re noble creatures – representing everything that F&F is not. What was I thinking?! Please accept my apologies.

Source: Nobody Looks Good in This Housing Mess

However, Sovereign Society Investment Director Eric Roseman says that by singling out 19 firms, the SEC has left hundreds more financial companies even more vulnerable. Washington Mutual (NYSE:WM), the largest US bank not included in the list, saw its share price plunge 35% last week.

Besides, poor financial supervision and weak government regulation created this mess in the banking sector, not short-selling hedge funds.

Bear markets tend to rear the government’s ugly head. In my book, the less government intervenes, the better. Markets should be allowed to function freely, as long as market participants use transparent reporting.

Sometimes, however, the government has to intervene when investors are unfairly punished or defrauded. This was the case earlier this decade during the Enron, WorldCom, Tyco, and the Spitzer mutual fund-timing scandals. Millions of investors were victimized, defrauded, and CEOs were subsequently sentenced or heavily fined.

But now the rules are about to change. It looks like short-sellers are the new target in the United States, the United Kingdom, and Australia.

In an effort to curb speculation in financial services stocks, the United States Securities and Exchange Commission (SEC) have introduced new short-selling rules for the next 30 days. These changes bar institutions, mainly hedge funds, from shorting financial stocks. The government has issued a list of 19 commercial and investment banks that cannot be shorted.

The SEC, announced these new rules last Tuesday after financial stocks plummeted for the second day. This announcement triggered a massive 17% rally for the bank index on Wednesday. The new short-sale rule was probably the biggest single factor contributing to the rally.

So will this new rule help financial stocks and their devastated shareholders? The answer is probably not.

Though the government has identified 19 financial institutions to be protected, this leaves a few hundred more that remain even more vulnerable as a result of this legislation.

Also, hedge funds and other speculators will find alternative targets. If a financial stock deserves to be priced lower, then it should trade at a discount to other more profitable companies. By isolating 19 companies, the SEC has invited vultures to the party as hundreds more are now fresh targets that are not protected by the 30-day rule.

Don’t blame the hedge funds for the woes afflicting the financials. The real blame falls on poor financial supervision, poor government regulation, and rogue CEOs that went absolutely wild issuing mortgages to sub-par applicants.

And don’t forget Wall Street. Investment banks, the largest of which are now protected by the Feds with the new short-selling rules, where the largest issuers and innovators of mortgage-backed securities tied to synthetic derivatives.

Source: What the SEC Really Accomplished with Their New ‘Short-Sell’ Rule

But the quest for better returns comes with greater uncertainty. That’s why investors have developed so many tools to take the edge off the potential surprises stocks can spring on them… from fundamentals like P/E ratios to technicals like trend lines. Not surprisingly, the academics in finance have worked on the problem, too. And boy do they have a deal for you. This one involves our new best friend, volatility. We’ve had two unusual tools for looking at volatility—Average True Range and Zigzag. Now we’ll look at the one that gets all the press and even went to college.

Suppose you had to choose one stock from several to buy, but you weren’t allowed to know anything about the companies. You aren’t allowed to ask about any of their strategies for growth or to find out whether they have enough cash flow and current assets to cover the bills. You don’t know their profit margins or even what business they are in.

Well fear not, oh lucky you. You can use the academic version of volatility to measure your risk. It’s called beta, and nothing could be more uncomplicated than this. It’s a miracle anything so understandable even got published, but it did and finance schools from coast to coast have embraced it.

Here’s the drill: If the beta is high, the stock is risky, though it could pay off well but there’s a lot of danger. If beta’s low, the stock will probably just hum along. The return may be market average or modest, but the risk is low.

So far, we’ve looked at volatility you can see with your eyes, volatility you can measure in dollars and sense (ATR). And volatility you can describe in percentage (Zigzag). The academic’s beta version is volatility measured yet another way—in comparison to the market. Usually, they use the S&P 500 as a stand-in for the market.

This measure assumes the market has a value of 1.0. Any stock that moves in tandem with the market, about the same amount also has a 1.0 beta.

If it moves twice as much, beta goes up to 2.0.

If it moves 20% less than the market, the beta falls under 1.0, to 0.8.

You get the idea. It can also be negative. If a stock moves half as much as the market, but in the opposite direction, the beta is -0.5. Most stocks fall between .5 and 2.5, with more of them clustered toward the higher end of the scale.

So now you know exactly how to find a safe stock. Yes, sir! You go buy yourself some Enron in 2000. You know it’s super safe because Enron only had a beta of 0.47.

Here’s your low beta— Enron 2000:

This is known as using damned lying statistics.So what if Enron is going to drop from $89 to 60 cents and you could have just looked at the actual facts of the business like cash flow instead of beta and avoided all that pain? As Warren Buffett has said, this is the kind of common sense that’s OK in practice, but it will never work out in theory.

Using beta-volatility as a measure of risk would lead you to a strange version of safety today as well. You might buy Warner Chilcott (beta 0.6), iParty (0.6) or Amcon Distributing (-0.5) or Education Realty Trust (0.2)—all companies with massive debt, poor growth and small to no profits. Any of those could be winners on some planet, but to call them low risk is like calling LeBron James medium-big.

Investors Behaving Badly

The Financial Research Corporation released a study prior to the [2001-02] bear market which showed that the average mutual fund’s three-year return was 10.92%, while the average investor in those same periods gained only 8.7%. The reason was simple: investors were chasing the hot sectors and funds.

If you study just the last three years, my guess is those numbers will be worse. “The study found that the current average holding period was around 2.9 years for a typical investor, which is significantly shorter than the 5.5-year holding period of just five years ago.

[While the research below is from a few years ago, recent studies show exactly the same, if not worse, results. Investors in general are not getting any better.]

“Many investors are purchasing funds based on past performance, usually when the fund is at or near its peak. For example, $91 billion of new cash flowed into funds just after they experienced their “best performing” quarter. In contrast, only $6.5 billion in new money flowed into funds after their worst performing quarter.” (from a newsletter by Dunham and Associates)

I have seen numerous studies similar to the one above. They all show the same thing: that the average investor does not get average performance. Many studies show statistics which are much worse.

The study also showed something I had observed anecdotally, for which there was no evidence. Past performance was a good predictor of future relative performance in the fixed-income markets and international equity (stock) funds, but there was no statistically significant way to rely on past performance in the domestic (US) stock equity mutual funds. I will comment on why I believe this is so later on.

“The oft-repeated legal disclosure that past performance is no guarantee of future results is true at two levels:

1. Absolute returns cannot be guaranteed with any confidence. There is too much variability for each broad asset class over multiple time periods. Stocks in general may provide 5-10% returns during one decade, 10-20% during the next decade, and then return back to the 5-10% range.

2. Absolute rankings also cannot be predicted with any certainty. This is caused by too much relative variability within specific investment objectives. #1 funds can regress to the average or fall far below the average over subsequent periods, replaced by funds that may have had very low rankings at the start. The higher the ranking and the more narrowly you define that ranking (i.e. #1 vs. top-decile [top 10%] vs. top quartile [top 25%] vs. top half), the more unlikely it is that a fund can repeat at that level. It is extremely unlikely to repeat as #1 in an objective with more than a few funds. It is very difficult to repeat in the top decile, challenging to repeat in the top quartile, and roughly a coin toss to repeat in the top half.” (Financial Research Center)

This is in line with a study from the National Bureau of Economic Research. Only a very small percentage of companies can show merely above-average earnings growth for 10 years in a row. The percentage is not more than you would expect from simply random circumstances.

The chances of you picking a stock today that will be in the top 25% of all companies every year for the next ten years are 1 in 50 or worse. In fact, the longer a company shows positive earnings growth and outstanding performance, the more likely it is to have an off year. Being on top for an extended period of time is an extremely difficult feat.

Yet, what is the basis for most stock analysts’ predictions? Past performance and the optimistic projections of a management that gets compensated with stock options. What CEO will tell you his stock is overpriced? His staff and board will kill him, as their options will be worthless. Analysts make the fatally flawed assumption that because a company has grown 25% a year for five years that it will do so for the next five. The actual results for the last 50 years show the likelihood of that happening is very small.

Tails You Lose, Heads I Win

I cannot recommend highly enough a marvelous book by Nassim Nicholas Taleb, called Fooled by Randomness. The sub-title is “The Hidden Role of Chance in the Markets and in Life.” I consider it essential reading for all investors, and would go so far as to say that you should not invest in anything without reading this book. He looks at the role of chance in the marketplace. Taleb is a man who is obsessed with the role of chance, and he gives us a very thorough treatment. He also has a gift for expressing complex statistical problems in a very understandable manner. I intend to read the last half of this book at least once a year to remind me of some of these principles. Let’s look at just a few of his thoughts.

Assume you have 10,000 people who flip a coin once a year. After five years, you will have 313 people who have come up with heads five times in a row. If you put suits on them and sit them in glass offices, call them a mutual or a hedge fund, they will be managing a billion dollars. They will absolutely believe they have figured out the secret to investing that all the other losers haven’t discerned. Their seven-figure salaries prove it.

The next year, 157 of them will blow up. With my power of analysis, I can predict which one will blow up. It will be the one in which you invest!

Ergodicity

In the mutual fund and hedge fund world, one of the continual issues of reporting returns is something called “survivorship bias.” Let’s say you start with a universe of 1,000 funds. After five years, only 800 of those funds are still in business. The other 200 had dismal results, were unable to attract money, and simply folded.

If you look at the annual returns of the 800 funds, you get one average number. But if you add in the returns of the 200 failures, the average return is much lower. The databases most statistics are based upon only look at the survivors. This sets up false expectations for investors, as it raises the average.

Taleb gave me an insight for which I will always be grateful. He points out that because of chance and survivorship bias, investors are only likely to find out about the winners. Indeed, who goes around trying to sell you the losers? The likelihood of being shown an investment or a stock which has flipped heads five times in a row are very high. But chances are, that hot investment you are shown is a result of randomness. You are much more likely to have success hunting on your own. The exception, of course, would be my clients. (Note to regulators: that last sentence is a literary device called a weak attempt at humor. It is not meant to be taken literally.)

That brings us to the principle of Ergodicity, “…namely, that time will eliminate the annoying effects of randomness. Looking forward, in spite of the fact that these managers were profitable in the past five years, we expect them to break even in any future time period. They will fare no better than those of the initial cohort who failed earlier in the exercise. Ah, the long term.” (Taleb)

Recently, at a party in New York, I mentioned that I had been talking to various groups in the United States and Europe about investment opportunities in the commodities market. Before I could get out one more word, a woman interrupted me. “Commodities!” she exclaimed, with the kind of incredulity in her voice that Manhattanites reserve for people moving to Los Angeles. “But my brother invested in pork bellies and lost his shirt. And he’s an economist!”

Everyone seems to have a relative who took a beating in the commodities market, and this fact (or fiction) is considered sufficient reason that no sane person would ever risk playing around with such dangerous things. That this particular victim was also a professional economist makes the warning seem even more ominous. I, however, couldn’t help laughing.

Billions of dollars are invested in the commodities market every day. Without the commodity futures markets, many of the things that you depend on in life, from that first cup of coffee in the morning to the aluminum in your storm door to the wool in your new suit, would be either scarce or nonexistent, and certainly more expensive.

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There are several other bromides out there for why “ordinary people” should not invest in commodities, and I want to lay these myths to rest, once and for all, so that we can get on with the more interesting business of how you can begin to make some money investing in the next-generation asset class.

About That Relative of Yours Who Got Wiped Out — He was inexperienced. You can learn. Most likely, he was buying on thin margin — the minimum deposit a broker requires to take a position in a particular commodity — and when the market went against him he lost big-time.

Here’s how it happens: Like stocks, commodities can be bought on margin. Unlike stocks, however, where by law you have to put up at least 50 percent of the price of the shares, the margins on commodities can be even lower than 5 percent: You can buy $100 worth of soybeans for $5. If soybeans go up to $105, you’ve doubled your money. Beautiful. But if soybeans go down $5, you’re wiped out. Not so beautiful.

Experienced, smart speculators can make tons of money buying on margin. They also know that they can lose tons, too. But they can usually afford it. Your relative was in over his head. If he had bought $100 worth of soybeans in the same way that he can buy IBM — for $100 (or maybe even $50) — he would be happy when it goes up $5 and a lot less sad should it go down $5.

Whenever I mention commodities in public, someone always points out that we now live in a high-tech world where natural resources will never be as valuable as they were when we had a smokestack economy. But if you read your history you’ll discover that technological advances are as old as history itself: The introduction of the sleek and beautiful Yankee clipper ship dazzled the world in the mid-nineteenth century, loaded with cargo, sailing down the trade winds at 20 knots and more, averaging more than 400 miles in 24 hours and able to make it from U.S. ports around Cape Horn to Hong Kong in 80 days; within a decade, the clippers had been replaced by the steamship, no faster but not dependent on wind power; and before long the next big thing in transport had taken over, the railroad, which, of course, was the original Internet — and prices in the commodities market still went up.

In the twentieth century came electricity, the telephone, and radio (three more Internets) and then television (a fourth Internet). There was also the automobile, the airplane, the semiconductor — and in the midst of all of these truly revolutionary technological breakthroughs came periodic, multiyear commodity bull markets.

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When the supply and demand in raw materials is seriously out of whack, the emergence of new technology will not necessarily restore the balance quickly. To be sure, changes in technology, for example, have made the economy less dependent on oil. But we still use plenty of it, and whenever there isn’t enough prices will rise. Computers or robots may do amazing things, but they cannot find oil or copper where there is none or make sugar, cotton, coffee, or livestock grow faster than nature allows. We can put in orders all day long on our computers for lead, but all that Internet technology will be in vain if there are no new lead mines. Technology can neither feed us nor keep us warm, and the demand for commodities will never disappear.

“But My Stock Broker Tells Me That Investing in Commodities Is Risky.”

Tell me again about all those Cisco shares you owned back in 2000. Or JDS Uniphase, or Global Crossing? So many risky stocks made the turning of the new millennium a not so happy time for many, who watched their portfolios evaporate.

If you do your homework and remain rational and responsible, you can invest in commodities with perhaps less risk than playing the stock market. You don’t need me to emphasize that investing in anything is a risky business. But let me point out something that you might not have realized: There has been more volatility in the NASDAQ in recent years than in any commodities index. Cisco, Yahoo! and even Microsoft have been much more volatile than soybeans, sugar, or metals. Compared with the risk record of most tech stocks, commodities look safe enough to be part of any organization’s “widows and orphans fund.”

And let me remind you of one more important difference between commodities and stocks: Commodities cannot go to zero, while shares in Enron can (and did).

Regards,
Jim Rogers

Cracking above 40,000 Deutsche Marks Per Kilo, the price of gold – when converted back from the Euros that German investors now clutch – promptly sank almost 14% from that 27-year top.

In the ensuing sell-off (to date) it bottomed (so far) at the equivalent of €561 per ounce on Tuesday. (You’ll note the caveats. The last real sell-off took the Euro gold price right down to a 20% loss.)

But our deep mistrust of technical analysis has failed to beat our fat crayons again. Because the gold market low (so far) coincides precisely with another key level in the metal’s long-term ascent:

The big “cathedral top” of May 2006…

The mainstream British and European press ignores pretty much all investment news by screwing its eyes tight and hoping the public won’t mind. Which we don’t, as a rule.

It takes some kind of mania to shake the mass of so-called “savers” to demand prices on tap (tech stocks at the end of ’90s; real estate until summer last year). Only a genuine scandal leads the press to wheel out a half-decent analysis (Enron, Northern Rock, Bear Stearns).

So it was disquieting to find gold splashed across the London media last month. Just as in May 2006 – the last blow-off top – the shiny yellow stuff even made an appearance in the tabloids, on radio and on breakfast TV. And the last time gold made headlines on the BBC news, any British, French, German or Italian investors choosing to buy gold lost one fifth of their money inside a month.

From 12 May 2006 to mid-June, the price vs. the Euro sank from €561 down to €450 per ounce. It took fully 18 months to recover that level, breaking it decisively at the very end of 2007.

And your crayon doesn’t need blunting to match that top with this week’s low (to date). So for now at least, that level – of €561 per ounce – marks the bottom of the latest plunge to clear weak hands out of the gold market.

Standing almost 14% below the new 27-year high hit on March 3rd this year, that former line of what professional chartists call “resistance” might just prove to be what they’d say is “support”.

If not, it will become “failed support” – the failure being the market’s fault, of course, rather than any error by the analyst or his thick wax crayon.

Adrian Ash
for The Daily Reckoning Australia

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