I call FNM and FRE “toy stocks”.

Countrywide (CFC) became a toy stock before it disappeared. Bear Stearns (BSC) became a toy stock before it disappeared. Subprime lenders like Novastar and New Century became toy stocks before they got delisted.

When a stock no longer trades based upon fundamentals and gets in the hands of speculators that love to treat it like a plaything, it’s a “toy stock.”

On a day like today, with FNM and FRE up over 30% from their open to their intraday high based upon Freddie Mac being able to borrow more money, these toys made some people happy. Just don’t confuse an investment with a toy.

There are a bunch of stocks that I obviously don’t get. Over time, approximately 68% of the 53,000+ signals at HEDGEfolios have been correct. However, there are a few stocks that I am chronically challenged by and when you take a look at the performance of past signals on any PROFILE page, you might run into one. For example, click on this link for Alcoa (AA). Inclusive of the current signal, I have been wrong on AA 13 out of 27 times since HEDGEfolios began (significantly below the 68%). That is not good and it is below what I expect of myself. But it is what it is and unfortunately, it is not the only one.

So why the confession? Portfolio management gurus will tell you the importance of identify and dealing with your trading weaknesses but don’t say much about how to actually do that. While I agree with that and as a general concept of going through life outside of trading, it is important to know your strengths and weaknesses. Nonetheless, I just don’t think it’s as easy as it sounds to identify a weakness and by definition, to learn how to overcome it. So I thought I’d share one of the ways I deal with this issue in the hope you might get something out of it.

If you’ve traded the same stock over the years, be objective and determine how many times you have been right. If it’s below your expectations, analyze what happened. Let’s say that you win 50% of the time, but your winners are significantly bigger than your losers. That wouldn’t concern me. However, if the situation is reversed or if your losers and winners cancel each other out, you should think about avoiding making trades in this stock.

For some reason, with the thousands of stocks that are available, too many investors get hung up on a small set that they trade over and over. If one of these stocks gets the better of your fundamental or technical analysis, make sure you recognize that if you decide to trade it again.

In my case at HEDGEfolios, I have committed to covering thousands of stocks and I don’t have the luxury of avoiding the ones that keep kicking my ass. So, I have a list of difficult stocks and when I am about to make a new signal in them, I try to evaluate whether I am making the same mistake.

In life, avoidance is not a way I advocate dealing with problems. However, in trading, as much as you’d like to believe you can identify a weakness and then modify your analytics to improve performance….I’d prefer avoidance. Learning from mistakes is great, but avoiding situations that encourage you to make the same mistake is greater. In trading, you will run into difficult stocks and it is not necessary to keep forcing the challenge.

Media and politicians are hyping Freddie’s $2 billion of debt offerings as a big win. They even go so far as to say this means that there is less likelihood that Fannie and Freddie will be nationalized. Click here for the hype.

I don’t see it the way they do. If you believe the government is going to take over, there is minimal risk to buying the debt at higher yields. I might be impressed if the Treasury came out a few minutes before the offering and said “We will not nationalize Freddie Mac” and then debt investors bought the debt anyway at market interest rates for 3-month and 6-month paper. But that is not what happened.  I might be impressed if they sold equity without a discount even though a bailout would wipe out that new equity. But that is not what happened. They offered new debt at high yields. That is not impressive to me. I don’t see this offering as any evidence that a government takeover is less likely.

During one of my research efforts in support of a different post, I came across this JP Morgan position piece (circa 2004) attempting to convince participants in trade transactions how useful CDS contracts might be.  Please click here and read it.

This nonsense is just one example of how far the industry is willing to go to promote “financial innovation”.   The CDS market is unregulated and apparently unlimited in its suggested applications.  It’s out of control and we are all at its mercy.

Last week, I implored bullish investors to Pay Attention to some early signs of weakening that I saw during my assessment of the market.  Now that another week has gone by, I am suggesting that you should Pay Closer Attention.  In general, many previously strong stocks are slowing and some are weakening.  Although this isn’t usually enough to encouraging me to change an UP signal to DOWN, it does change my behavior. When this happens, I pay closer attention and tend to be more cautious about putting on new longs and more aggressive about exiting.   The light volume that typically occurs in the three weeks preceding Labor Day makes market assessment very difficult.  Some commentators tell you to downplay or almost ignore what happens during this period and wait until the big players get back from vacation.  To me, that’s crappy advice and instead, I just ask you to pay closer attention.

The psychology of looting is an interesting phenomenon. First you have an emergency like a flood or hurricane or earthquake or civil unrest and the anger and frustration just boil over at a time when law enforcement is overburdened with the actual emergency and doesn’t really have the capacity to deal with the looting. Normal law-abiding people suddenly turn into criminals and an attitude of “gotta get mine” or “I gotta get me some of that” takes over. Hey, if the other guy is taking stuff, I guess it must be okay for me to share in the goodies. After all, most of us have been cheated by society to a sufficient degree to feel entitled to getting some of what was either taken from us or not given to us so looting isn’t really stealing …is it?

Of course I am being ridiculous in this observation. Looting is a crime. Although, I am constantly amazed by the non-looters who often show some deeply absurd compassionate understanding and suggest that the looters really didn’t commit a crime. I have no compassion for any of it.

What does looting have to do with stocks and our economic situation enough for me to discuss it here? I see deep analogies to the bailouts in the financial industry and the psychology of looting that was exhibited by the automakers who I think finally said “I gotta get mine” with their request for $50 billion or so in government loans. We have an emergency, our regulators/politicians are overburdened trying to deal with the emergency and then the mob shows up to loot. And of course, there are the bystanders who show compassion for the auto industry who have apparently not been given enough help and suggest that it’s only natural that we should give them more during the emergency.  I have no compassion for looting.  GM, Ford and Chrysler are showing up to loot.  It’s as simple as that.

Last year I jokingly complained that I got No Jackson Hole Invitation.

The Federal Reserve Bank of Kansas City is sponsoring its big economic symposium in Jackson Hole at the end of this week and I’ve not been invited. There’s no skiing this time of year but I’d still love to be there. It’s a tough ticket with only about 100 invites going out to the Fed members and other “prominent central bankers, finance ministers, academics, and financial market participants from around the world.” Obviously, I would never expect to be in this crowd and I have no idea what really goes on there. But my impression is that it’s groupthink at its worst. One economist debating with another economist might lead to an economics lesson, but I wonder what it means for the rest of us. For example, Chairman Bernanke’s Friday morning lecture is entitled “Housing and Monetary Policy” and while I am sure the past few weeks have provided a few good revisions to the final draft, what will it do? Who will hear it but a bunch of the same people who have contributed to the mess that we now have?

Guess what? I didn’t make enough (read none) friends at the Fed lately(read never) to garner an invite this year either! It’s funny even thinking how long I would be able to hold in the laughter if I was there listening to these brainiacs or how long it might take to blurt out a few “BULLSHIT!” interruptions as they discussed their policies or economic predictions. It’s better for all of them that people like me are not there. After all, would you really want to compare thoughts and predictions on the likely consequences of government intervention policies and economic statistics from someone like me to the leading economists on the planet?

Speaking of that - maybe you should reread last year’s Jackson Hole speech by Bernanke(click here) and now that we have the benefit of hindsight (and lots of it) to determine whether he said anything so insightful last year that helped us out over the past 12 months. I didn’t find much other than this nice comment about half way through:

Ben Bernanke ……”It is not the responsibility of the Federal Reserve–nor would it be appropriate–to protect lenders and investors from the consequences of their financial decisions.”

Oh well, none of this is important. What matters is the perception that he and his Jackson Hole buddies know what to do. HMMMMM!?! I am having flashback hell right now.

Rewind to last year…on the day when Bernanke spoke. Here is what I wrote about getting impressed by Knowing What We Should Already Know.

As you should know, I despise credit default swaps and the extreme risk that I believe they pose to the world’s financial system. Furthermore, I suggest that they are the largest fraud in history both in a figurative sense (with the claim that they actually reduce systemic risk) and in a legal/literal sense (insurance is being sold by people who either never intend to pay when a credit event happens or who know they have no ability to pay out(see Bear Stearns). And yet, it goes on and on and expands exponentially and nothing I say will change it. So I just watch in amazement and make a few observations about the absurdity. Please spend some time evaluating the trading in Fannie and Freddie CDS contracts both months ago and in the past few days.

Here’s a great example from Bloomberg. It will be very interesting to see how much insurance will be paid out for the GSEs bondholders (either senior or subordinated) on debt that will likely be assumed by the Treasury before or after Fannie and Freddie own up to being insolvent. I thought about using the Countrywide CDS or the Bear Stearns CDS situations as an example, but while there are similarities - this Fannie and Freddie mess is too unique. Regardless, please spend some time thinking through what kind of insurance is either being bought or sold with the Fannie and Freddie Credit Default Swaps. And more importantly, what counterparties will be able to make payouts if they are ever required?

When Dick Bove of Ladenburg Thalman got sued for issuing a report that BankAtlantic didn’t like, I wrote my thoughts on Suing Analysts and suggested that there are No Lawsuits when an analyst says something nice that pumps up a stock price whether it is rumor-based or turns out to be factual.  So I got a good chuckle out of Bove yesterday with his upgrade of Lehman and its effect on the market.  Followed by today’s story about the State-run Korea Development Bank having an interest in buying a big chunk of Lehman, we now have a 15% spike in LEH and a few hundred points on the Dow.  How perfect!  Thanks for pointing out the absurdity of both situations, Bove.  Of course, as predicted, Lehman was unavailable for comment.  Of course, Bove’s comments yesterday were just based upon his speculation that the bank would be a takeover target.  Of course, there will be no warnings from regulators about starting rumors.  Of course, there will be no questions about whether there was a Reg FD leak to a specific analyst about a story that gets reported the following day.  Of course, there will be no lawsuits from Lehman.  Does this good rumor deed helping to prop up a key stock in the financial sector and lifting the market make up for making negative comments?

Last week, I met with a writer who is evaluating some book ideas. During our conversation, she made an intriguing comment about the connection between the S&L crisis and our current credit crisis. Since then, I’ve spent some time reading through the history and it is more than ironic that something widely credited for solving some problems for the Resolution Trust Corporation has evolved into something I credit for creating many of the problems we are now facing.

Please read Securitizations (by clicking here.)

Here are some of my favorite snippets.

The RTC’s Oversight Board did not support the RTC’s issuance of securities backed by a full government guarantee. That lack of support stemmed partly from concerns raised by the Department of the Treasury that (1) the government would retain all of the risk because there was no real asset sale, and (2) issuing a new security with a full faith and credit guarantee by the U.S. government would compete with the securities issued by the Treasury. As a result, the RTC did not use a government guarantee to enhance the credit of RTC securities. Instead, the RTC decided to use cash reserves and other methods to provide credit support. It issued publicly rated mortgage-backed securities for which the senior securities were rated in the two highest rating categories by at least two national credit rating agencies.

In light of the Fannie and Freddie bailout that appears imminent, can you imagine a Treasury that fought for such principles? Oh well…back then I guess they thought high ratings from the credit rating agencies would suffice. Interesting to see how that ratings game was played so long ago. Now that isn’t so workable so it seems we just skip all that and skip the whole “full faith and credit guarantee by the U.S. government” and just nationalize the whole system.

Here is another fun one.

Rating agencies evaluate the transaction structure, the underlying pool of assets, and the expected cash flows, and determine the extent of loss protection that should be provided to investors through various forms of credit enhancement. Securitization transactions typically involve the use of credit enhancement to create securities that have a very high level of credit quality. To achieve the highest ratings from the national credit rating agencies, mortgage-backed securities must satisfy cash flow, delinquency, and loss coverage tests that make default almost impossible. The rating agencies have developed loan loss models to estimate the required level of loss protection for a securitized mortgage loan pool. They use the Great Depression as a benchmark to estimate the level of losses that may occur if a mortgage pool is subjected to stressful economic conditions. Cash flow scenarios are run that subject a pool of mortgages to “stress tests” for which losses and delinquencies are assumed to be two to three times greater than the losses experienced in the Great Depression. The rating agencies monitor the performance of the transaction over time and adjust credit ratings as appropriate.

Is that the way it worked back then? HMMMMM!?!

And my personal fave….

During the structuring process for the first RTC securitization transaction, the issue of whether to include delinquent loans (loans for which payments were more than 30 days late) in the pool arose. The industry standard is to exclude delinquent loans when forming a collateral pool for any new offering of mortgage securities. This practice exists because the rating agencies require much higher credit enhancement levels for delinquent loans and diverging from this practice might make the securities appear less attractive to investors. The concern was that there would be a tremendous pricing concession associated with the inclusion of these loans, in addition to a substantial increase in the reserve fund. The underwriter for 1991-1 conducted a sensitivity analysis to determine the impact of including delinquent loans. The analysis used a “delinquency pricing concession” to estimate the above-market level yield premium that would be demanded by investors to compensate for the inclusion of those loans in the pool. As a result of the analysis, which valued the pricing concession at 0.05 percent, the RTC decided to include loans that were up to 89 days delinquent in the sale pool. This was the first time mortgage-backed securitization transactions had included delinquent loans.

The birth of the subprime tranche concept! It was not an immaculate conception after all!

In conclusion…..

The RTC managed the liquidation of $402.6 billion (book value) in assets. Of this amount, approximately $193 billion (about 48 percent) represented residential, multifamily,and commercial mortgages. More than $42 billion (almost 22 percent of the mortgages and more than 10 percent of all of RTC’s assets) were sold through the RTC’s securitization program. When the RTC was dissolved on December 31, 1995, only $8 billion of the original $402.6 billion in assets remained to be liquidated. The RTC’s liquidation program was therefore deemed successful. Some of that success must be credited to the securitization process. The securitization disposition strategy used by the RTC created new markets with strong participants. These strategies also paved the way for an increasing number and variety of issuers seeking convenient and expedient ways to recapitalize “nontraditional” mortgage loans.

SUCCESS!!!! I like that part about “new markets with strong participants” and of course the “convenient and expedient ways to recapitalize “nontraditional” mortgage loans.”

I am not suggesting that Bill Seidman (somebody I deeply respect) and the RTC did a poor job or that securitizations or RMBS or CMBS are bad things. I was just intrigued by the connections between the two crises and how something seen as such a success evolved into such a disaster.