#$fnma

On Monday night, more than eighty million Americans watched our two candidates for president argue more about missing tax returns, deleted emails, and a former beauty queen than the issue that matters most to our country’s health and prosperity: economic growth.

When our economy grows rapidly, as it did during the Reagan and (Bill) Clinton administrations, good things happen. Home ownership increases, budget deficits shrink (Mr. Clinton produced a surplus his last four years), crime drops, and America’s influence increases worldwide. Unfortunately, our gross domestic product hasn’t grown more than four percent a year since the end of the last century, and I don’t see it topping that critical figure again anytime soon.

In both 2014 and 2015, US GDP expanded at a subpar 2.4 percent rate. The first half of 2016 was even more sluggish. GDP grew only one percent. While both George W Bush and Barack Obama inherited messes when they came into office—the terrorist attacks of 9/11 took place early in Bush’s first term and Obama had to contend with the fallout of the 2008/2009 financial crisis—each deserves a C-, at best, for their economic oversight.

I fear Hillary Clinton or Donald Trump will do no better. Hillary wants to increase personal income taxes, increase regulation of our fossil fuel industry, and keep the US corporate tax rate at 35 percent. Meanwhile, Trump’s anti-immigration rhetoric—immigrants, legal and illegal, start one-third of new businesses—and threatened trade wars could push our anemic economy into another recession. One wonders if Mr. Trump has ever read about, or even heard of, the ill-fated 1930 Smoot-Hawley tariff act and how it kick-started the Great Depression. I doubt it.

Here are seven straightforward tax and policy proposals that many economists agree would stimulate economic growth:

1) Lower the US corporate tax rate from 35 percent to the worldwide average of 20-22 percent and adopt a ‘territorial tax’ where offshore profits of US corporations are not ‘trued up’ to the higher US rate when those profits are repatriated. This would all but stop the ongoing inversions of corporate headquarters abroad and induce companies to bring offshore profits back to America. All told, S&P 500 companies now hold over $3 trillion in cash and earnings outside of the US, according to a recent report by Credit Suisse. Apple alone is sitting on more than $200 billion in offshore cash. Imagine how many jobs and opportunities even a portion of those enormous sums could create if our tax policy incentivized businesses to invest foreign earnings here at home?

2) Eliminate ALL income tax deductions. The US tax code was already a complicated mess almost forty years ago when President Jimmy Carter called it “a disgrace to the human race.” It’s far more complicated now. This leads to lower growth, ill-advised investment decisions, and money wasted preparing and filing tax returns. Contrary to popular opinion, most deductions benefit the upper middle and upper class. The ‘big five’ deductions are health insurance premiums, mortgage interest, state income taxes, charity donations, and retirement plans. Because every American already receives a standard deduction of $6300 for single taxpayers and $12,600 for married, these itemized deductions almost exclusively lower the tax obligations of the well-off while depriving the US Treasury of roughly $400 billion annually, vs. our total budget of $4 trillion.

3) Reduce the number of tax brackets from today’s seven to two or, at most, three. As importantly, the highest rate should be below 30 percent. Studies show that a higher top rate increases the likelihood taxpayers retire, cheat, or move away. While a single rate ‘flat tax’ sounds appealing, it is not equitable and more importantly is not politically feasible. I believe those who make large amounts should pay a higher rate than those who earn little. But I also believe the lowest rate should apply to most wage earners. Everyone needs ‘skin in the game.’

4) Adopt a balanced budget amendment. This would force politicians to stop (or at least slow) the explosion in our nation’s current $19 trillion in debt. Someday, possibly soon, investors worldwide will stop buying US bonds at today’s all-time low interest rates. When/if that occurs America’s annual interest cost will double to over $1 trillion. This will ‘crowd out’ other government spending, leading to a recession. Or worse.

5) Wind down Fannie Mae and Freddie Mac. These two quasi-governmental agencies, which purchase and securitize mortgage debt, exacerbated the 2008/2009 housing crisis. They could do so again as lenders make questionable home loans knowing they can quickly sell them (and book profits) to Fannie and Freddie. In her recent book Shaky Ground, author Bethany McLean wrote that many observers, including President Obama and former Fed chief Paul Volcker, support closing these entities. While this would increase mortgage rates from 1/4 percent to possibly one percent, it would stop the risk Fannie and Freddie pose to America’s taxpayers.

6) Fix Social Security and Medicare. Without changes, Social Security will deplete its current surplus within 20 years. Government economists believe recipients will receive, at most, 70 percent of promised benefits when that occurs. There are only three options to avoid this: reduce benefits, increase payroll taxes, or do a little of both. A start would be to ‘means test’ benefits, reduce cost of living increases, and lift the amount at which payroll taxes are collected. Fixing Medicare is more complicated, but we have to allow Medicare/Medicaid programs—which buy about half of all health services—to negotiate directly with pharmaceutical companies, medical device manufacturers, and other health care providers.

7) Offer Medicare to all American taxpayers. The current Obamacare hybrid is destroying jobs because it forces corporations to pay health care premiums for a growing percentage of their employees. Many have responded by hiring fewer folks. If a government health plan was available to all Americans (and everyone with income above a nominal amount could buy that plan, another plan, or pay a substantial penalty), corporations could shed the burden of providing health benefits and focus on what they do best.

 It has been a rough year for hedge funds and, in particular, long / short hedge funds. Ben Carlson has an informative post on why that category of funds has been among the worst to suffer. Among, the long-short hedge funds one of the toughest years belongs to Bill Ackman’s Pershing Square. 

Ackman recently released his Q3 letter he warned investors:

If the year finishes with our portfolio holdings at or around current values, 2015 will be the worst performance year in Pershing Square’s history, even worse than 2008 during the financial crisis when the funds declined by 12% to 13%.

Barring a miracle, the hedge fund is likely to finish down 20 percent. As we noted earlier on Twitter, Ackman is down 19.5% through December 22nd (see chart). In Ackman’s defense, he does run a concentrated portfolio and is more of a long-only investor (Herbalife is the only real short position since his campaign against MBIA many years ago). 

Even with the S&P flatish, Ackman’s over-concentration in pharma certainly hurt returns. Ackman is a polarizing figure but regardless of one's thoughts he is shrewd and writes good letters. See below his comments on VRX, FNMA, FMCC and HLF followed by a link to the full letter.

Valeant (VRX)

Valeant’s stock price declined significantly in the quarter as a result of statements by politicians regarding drug price increases, subpoenas from regulators, attacks by short sellers, and the termination of Valeant’s relationship with Philidor, a specialty pharmacy distribution channel used for dermatology products. 

On October 30, 2015, we held an investor conference call to answer the many questions we received about our investment in Valeant.Approximately six weeks ago, Valeant’s board formed an ad hoc committee to investigate the recent allegations made against Philidor, including claims that Valeant management was involved in the alleged wrongdoing at Philidor. 

The committee has hired former U.S. Deputy Attorney General and Kirkland & Ellis partner Mark Filip to lead the investigation.Valeant will hold an in-person, half-day investor meeting tomorrow, Wednesday, December 16th, to provide updated financial guidance for 2016, review the company’s strategy, and answer investor questions. We believe that this is an important step for Valeant to restore investor confidence.

On November 23rd, we filed a 13D reflecting our increased stake in Valeant. Before we increased our position, we did substantial due diligence by re-underwriting our investment in the company. In particular, we reviewed all of the short sellers’ allegations, the potential political and regulatory risks, the impact of the shutdown of Philidor, and the company’s capital structure, debt covenants, and overall financial risk. We updated our financial model in light of recent business developments in order to better assess free cash flows, how quickly the company would be able to reduce leverage, the probability of financial distress, and to determine a conservative estimate of Valeant’s intrinsic value.

Ultimately, we concluded that the risk of bankruptcy or financial distress was de minimis in light of (1) the highly cash-flow-generative nature of the business, (2) the minimal debt maturities over the next several years, (3) the nature of Valeant’s financial covenants, and the highly diversified (both by therapeutic area and geography) product portfolio. Because Valeant owns a highly diversified, divisible, and desirable portfolio of products that can be soldproduct-by- product and/or division-by-division in an industry with many well-capitalizedbuyers, it could deleverage at an even more rapid rate if it chose to do so. 

Once we determined that the risk of financial default was extremely small and the stock was trading at an enormous discount to intrinsic value, we considered various approaches to increasing our investment.Generally, we purchase stocks outright to get exposure to a particular investment. In this case, we took advantage of the high volatility of Valeant stock, its extremely low share price, and the high degree of market uncertainty in choosing to build a position that offered us a compelling reward for the potential risk. 

Rather than purchase common stock outright, we increased our investment through a contemporaneous series of over-the-counter option transactions. The bulk of the increase in our investment in Valeant was created through the sale of European-style putoptions struck at a $60 stock price, the purchase of American-style call options at a $95 stock price, and the sale of European-style call options at $165 stock price, all of which expire in January 2017. 

This derivative position gives us the upside of the stock from $95 per share up to $165 per share until January 2017. The net purchase price of the options was $6.75.In summary, if the stock rises to $165 or more by January 2017, we will make more than 10 times our net investment over this period. Our downside is equal to the net purchase price of each option plus the decline in the stock price, if any, below $60 per share as of January 2017. By selling European-style put options, the shares cannot be put to us until January of 2017. 

By then, we estimate that Valeant’s stock price will be substantially in excess of $60 per share, potentially several multiples of this price.The upside of our derivative investment is approximately equal to that of owning the stock outright at $95 per share with 30% less downside, i.e., if the stock were to go zero, we would lose approximately $67 per share, (the put strike price plus the net option premium). By selling two options for every option that we have purchased, we have also minimized the effective cost of this investment and limited the impact of rapid time value decay which is characteristic of an outright option purchase on a highly volatile stock. 

In a worse-case scenario, which we believe is extremely unlikely to occur, we risked approximately 4% of additional capital on this investment while increasing our notional exposure to Valeant by about 6% of the portfolio.We added to our investment because we believe that Valeant shares are enormously undervalued. While we expect a degree of disruption to Valeant’s dermatology business, we believe that the fundamentals of Valeant’s overall business remain strong. Just this morning, Valeant announced a 20-year agreement with Walgreens Boots Alliance, Inc., the largest pharmacy chain in the U.S. with more than 8,000 units, which will “more than replace” Valeant’s Philidor specialty pharmacy distribution. 

We believe that this agreement will go a long way to addressing concerns about the disruption to Valeant’s dermatology business by expanding convenient and affordable access to Valeant products, and will help restore credibility by the company partnering with the largest and best-managed pharmacy chain. 

The agreement provides for discounted pricing for Valeant’s dermatology and ophthalmology products reducing costs for the health care system.Valeant’s stock price is currently impacted by the high degree of uncertainty created by the shutdown of Philidor and the corresponding investigation of allegations, recent political scrutiny of the pharmaceutical industry, negative press coverage of Valeant, and technical trading factors. 

These technical factors include: (1) the large amount of tax-loss selling which will likely continue until year end, (2) redemption-related sales from funds whose performance was affected by the decline in Valeant’s stock price, (3) “window dressing” where investment managers who held Valeant stock sell it before year-end so they do not need to show their investors the actual losses they incurred holding the position, and (4) the inherent complexity of the company that requires substantial due diligence before new investors establish their investment.Because of the controversy around Valeant, many portfolio managers have been unwilling to retain an investment in the company as client scrutiny and headline risk became intolerable.

In light of the above technical factors, we believe that most new investors would prefer to wait to establish an investment in Valeant until after the upcoming analyst day and when year-endtechnical factors abate

.There are a number of relatively short-term catalysts that we believe may lift the overhang on Valeant shares. We expect that this morning’s announcement will reduce if not eliminate concerns about disruptions in the distribution of Valeant’s dermatology products. 

We expect that additional uncertainty will begin to dissipate at tomorrow’s analyst day when the company will announce its revenues and earnings guidance for 2016 and answer questions from existing and prospective investors. In addition, we expect the results of the Philidor investigation to be announced sometime in the first quarter of next year. 

The company will likely file its 10-K in February with the results of Price Waterhouse’s year-end audit. This should comfort investors who have concerns about Valeant’s accounting.While we expect a messy fourth quarter due to the shutdown of Philidor and investigative costs, the company should be able to post “clean” quarters beginning in the second quarter of next year. With the passage of time, the reduction in uncertainty, increased transparency, the reporting of operating results which we anticipate to be strong, along with the deleveraging of the balance sheet, we expect Valeant stock to rise substantially.

...........

Fannie Mae (FNMA) / Freddie Mac (FMCC)

The GSEs’ continue to show healthy underlying trends in their core guarantee business, which have been obscured by non-cash, accounting-based derivative losses in the GSEs’ non-core investment portfolio. 

Changes in the value of the derivatives create enormous volatility in the GSEs’ GAAP quarterly earnings, even though they do not have an impact on economic earnings or intrinsic value. 

Because the net worth sweep does not allow the GSEs to retain capital, it is likely that future accounting-based derivative losses could cause the GSEs to borrow additional funds from Treasury despite having no economic need to do so. 

This is yet another example of why the Net Worth Sweep is problematic.Since our last call, there has been a growing belief among highly regarded and politically influential groups and thought leaders that the GSEs must retain capital and exit conservatorship. 

Substantial questions have been raised about the government’s legal justification for the Net Worth Sweep. We encourage you to read Gretchen Morgenson’s December 13th New York Times article on the GSEs entitled: “Fannie and Freddie’s Government Rescue Has Come With Claws,” which can be found here:http://www.nytimes.com/2015/12/13/business/fannie-and-freddies-government-rescue-has-come-with-claws.html?ref=todayspaper&_r=0.

Recently, the Community Home Lenders Association and Community Mortgage Lenders of America, two organizations representing the politically powerful community banks, wrote a letter to the White House arguing for capital retention and an end to conservatorship for the GSEs. 

There have also been reports that the White House is considering various alternatives for recapitalizing the GSEs. Although government officials have denied these reports, we find it interesting that these reports have surfaced amid a growing consensus that a recapitalization of the GSEs is needed.At the end of October, a shareholder of both Fannie and Freddie’s common stock filed suit against the Net Worth Sweep in Kentucky. This case provides another avenue for pressing the case against the Net Worth Sweep in addition to the cases in the DC District Court of Appeals and the Federal Court of Claims.

The GSEs underlying guarantee business is in healthy shape, the momentum for capital retention and an exit for conservatorship are growing, and the legal avenues for fighting the Net Worth Sweep have increased.

.......................

Herbalife (HLF) Short

Our thesis on HLF remains unchanged. We believe that Herbalife will ultimately be subject to regulatory action or will collapse because of fundamental deterioration in its business which relies on the continual recruitment of new victims. During the quarter, the potential for regulatory action increased while business fundamentals deteriorated.

From a regulatory perspective, we view the Complaint that the FTC filed on August 17th against Vemma Nutrition Company (“Vemma”), another MLM whose structure is similar to HLF’s, as a very positive development. The preliminary injunction issued against Vemma on September 18this likely to make Vemma’s business totally unviable and provides a template for claims the FTC could bring against Herbalife.

On October 27th, New York State Senator Jeff Klein, working with Public Advocate Letitia James and a non-profit community group called Make The Road New York, released a critical report on Herbalife titled: “The American Scheme: Herbalife’s Pyramid Shakedown”. Based on its hidden camera investigations of more than 60 nutrition clubs located in New York City, the report concluded that Herbalife distributors are “running an illegal pyramid scheme.” 

The report was supported by data from 56 victims who individually lost as much as $100,000. On December 9th, Sen. Klein held a public roundtable to advance his campaign to stop Herbalife’s deceptive tactics. Senator Klein has proposed New York State legislation that would amend the New York State General Business Law to better protect New York State residents.Despite predictions from Herbalife supporters that regulatory investigations would end during the quarter, they appear to have intensified. 

The company has now spent a total of $101 million defending itself, including $11.2 million in the quarter. Expenses related to “responding to governmental inquiries” increased from $5.8 million last quarter to $7.6 million this quarter which reflects the growing intensity of ongoing investigations. 

Assuming Herbalife is spending about $500 per hour on lawyers, $7.6 million represents 15,200 hours of legal time during the quarter, or 168 hours of legal time per day, seven days per week. 

Herbalife’s fundamentals continued to decline during the quarter. Notably “total members” – perhaps Herbalife’s most important operating metric – declined from 4.1 million in the second quarter to 4.0 million in third quarter indicating that Herbalife churned through at least 500,000 members as the rate of member churn exceeded Herbalife’s ability to find new victims.

On its conference call, the company also began using a new operating metric called ‘active members,’ suggesting that Herbalife concedes that a proportion – we expect, a large proportion – of its members are inactive. In our experience, companies that change the standards by which they measure themselves do so only when the old metric shows business deterioration that they would rather not disclose.With respect to third quarter earnings, 

Herbalife posted weak revenues, but was able to reduce or defer certain expenses in order to generate earnings that exceeded analyst estimates. Among other questionable add-backs, Herbalife excludes regulatory and costs to “defend its business model” from its earnings estimates despite the fact that these expenses are likely to continue. On a consolidated basis, the company reported net sales of $1.1 billion, down 12% year-over-year,which was worse than Street expectations and below management guidance. The negative variance was largely attributable to foreign exchange headwinds. Similar to last quarter, China continues to be the key driver of Herbalife’s growth. 

While China’s year-over-year growth was 25%, Herbalife China revenues declined 5% when compared to the previous quarter.Notably, HLF’s South Korean market continued to show substantial deterioration in the quarter. South Korea has been one of Herbalife’s largest markets and a significant driver of the company’s revenue and earnings growth. Over the last several years, South Korea has been Herbalife’s third or fourth largest market and one of its most profitable with approximately 56% contribution margins versus 43% for the rest of the company. 

Beginning a year ago, Herbalife Korea began to decline. This deterioration accelerated notably this quarter, down 39% versus last year on a constant-currency basis, and down 46% on an actual basis.While management continues to blame the decline in Korea on “changes in the business model,” to us this looks like the classic “pop-and-drop” that is pervasive in pyramid schemes, a phrase that CEO Michael Johnson previously used to describe Herbalife’s rapid growth and inevitable decline in certain geographical regions. 

If one is looking for obvious evidence that Herbalife is a pyramid scheme, one need only look at the massive growth and rapid decline of Herbalife’s South Korea business and compare it with Unilever or another legitimate consumer packaged goods company.

See the full letter here

Get our free daily or weekly newsletter , follow us on Twitter, Tumblr, like us onFacebook, connect with us on Linkedin

(Only if you’ve got billions to spare, plenty of lawyers, and questionable ethics.)

On the plane ride back from the Booth Investment Management Conference in Chicago on Sunday, I read the great new book by veteran financial journalist Bethany McLean, Shaky Ground: The Strange Saga of the US Mortgage Giants. The book tells the story of Fannie Mae and Freddie Mac, the two massive GSEs (government sponsored enterprises) that buy, package, and sell pools of mortgage loans. It’s a fascinating, if distressing history. Unfortunately, because our government failed to do away with Fannie and Freddie during the 2008 financial crisis, that history is still unfolding.

Fannie Mae was a government agency until 1968, when it was “privatized” by President Johnson, partly to pay for the Vietnam War. Freddie was created by Congress in 1970 to both compete with and complement Fannie. As with so many government programs, the initial purpose of Fannie and Freddie was laudable—to help increase homeownership. But, as with so many government programs, those good intentions have had disastrous unintended consequences.

By early 2008, Fannie and Freddie were guaranteeing 80 percent of all US mortgages, up from 40 percent just a few years earlier. All told, the two GSEs had packaged and sold over $5 trillion of outstanding mortgage debt. Roughly 20 percent of that securitized debt was held by foreign investors, with the central banks of China and Japan owning about $1 trillion between them.

At the time, Fannie and Freddie only had a sliver of capital—about $84 billion—so when the financial crisis exploded and homeowners defaulted on their mortgages in record numbers, both firms quickly required an immediate bailout. The path not taken (and the correct path, in my opinion) would have been to put them into bankruptcy, or receivership. For years, smart folks on the left and the right had wanted to wind down Fannie and Freddie. (In 2011, former Federal Reserve head Paul Voelker said the financial crisis “was the opportunity to get rid of institutions that shouldn’t exist.”) But then-Treasury Secretary Henry Paulson was concerned that if foreign buyers of GSE securitized paper were burned, they might stop buying US Treasury debt (which we need to fund our $18 trillion federal debt) so he opted for conservatorship instead.

The terms of the deal were complicated. The government injected over $200 billion, and took 79.9 percent of both companies. Dividends on Fannie and Freddie preferred shares were suspended, and it was implied that if either company paid these dividends again, the funds would go to the US Treasury. This is where it gets interesting, because both entities are making sizable profits again. As of earlier this year, they had paid $231 billion back to the US Treasury. You’d think their stocks would be climbing back towards pre-crisis highs. Instead, they’re barely above $2. Why? In 2012, the federal government changed the bailout terms and is now directing all of those profits to Washington.

Last week, an article in Fortune magazine dubbed this rule switch a de facto nationalization of Fannie and Freddie. To which I say: so what? Government created these monsters. If it’s not willing to kill them off entirely, why shouldn’t it use their earnings to help pay back some of the staggering national debt?

Not surprisingly, some people on Wall Street see things differently and want those profits transferred from the US Treasury to their own pockets. A handful of a high-profile, multi-billion dollar hedge fund managers sensed an opportunity when the preferred stocks of Fannie and Freddie were trading for pennies. Now, they’re clamoring for the companies’ dividends to flow back to them. Pershing Square’s Bill Ackman has even claimed that Washington has “stolen” those funds. Multiple lawsuits have been filed. Some have already been thrown out and are working their way up the appeals system. If successful, these actions could result in what Bloomberg called “one of the biggest potential payments in history.” 

Taxpayers 1, billionaires 0.   One of the myriad of lawsuits led by a “who’s who” of hedge fund tycoons got tossed out in Federal district court.  Wall Street titans such as Bruce Berkowitz, Carl Ichan, John Paulson, David Tepper, and Bill Ackman thought it was a good idea to buy the common and preferred shares of Fannie Mae and Freddie Mac.   Yet, the conservatorship of the mortgage giants has denied these shareholders any future dividends.  In my book, that makes these shares pretty much worthless.  On Wednesday, October 1, 2014, after the decision by federal district court, Fannie Mae and Freddie Mac’s stock fell over 30 percent because their chances of ever seeing a dime are approaching zero after the ruling.  Intraday on October 2, 2014, both over the counter stocks (FNMA) and (FMCC) were still falling by over 10 percent.  On October 2, both company’s common stock opened at about 25% of their 52 week high.

This trade was so crowded by large funds and was so devastating to their bottom lines, that these funds may have been liquidating good stocks just to keep ahead of margin calls and the inevitable investor redemptions.  Investors tend to drop funds that post big losses.  This author warned that investing in mega hedge funds, above $1 billion in assets, is fraught with risk and statistically produces subpar returns because of the big funds’ inability to move into and out of positions easily.  This problem is exacerbated by many funds crowding on the same side of one trade as happened in the Quant meltdown of August 2007.  The 1.3 percent drop yesterday in the S&P 500 (SPY) after a good report of private sector jobs growth could have been partially caused for this race to the exits by the mega funds.   The Sage of Omaha, Warren Buffett, was so unconvinced that the fundamentals warranted the price action on Wednesday, October 1, 2014, that he said to CNBC that he was buying stocks.

This Frannie trade seems to be one of political ineptitude.  The mortgage giants were bailed out by taxpayers to the tune of $188 billion from certain bankruptcy in 2008.  The government only did this because their bonds make the 30 year fixed rate mortgage possible.  Without Fannie and Freddie, many households could not afford to own a home, “The American Dream.”  The optics of the trade are terrible, these high profile billionaires are trying to take money taxpayers earned.  Perhaps these robber barons, attending the Robin Hood Foundation dinner last night, also want to smash an apple pie over Mom’s head while they try to burn down the house with a white picket fence and American flag on the porch.   That might hurt their public image less.  I know these funds can spend their investors’ money on the best lobbyists that money can buy, but no amount money can win a losing cause.

Photo © 2011 J. Ronald Lee  Creative Commons 2.0

For decades, taxpayers had been propping up these government sponsored entities (GSEs) with implicit guarantees on their debt.  Private shareholders, whose shares are the topic of these court cases, oversaw Fannie and Freddie when they wiped out the lender’s capital in the housing meltdown.  In August 2008, the Housing and Economic Recovery Act (HERA) gave the Federal Housing Finance Agency the right without judicial review to wipe out the claims of any securities issued by Fannie and Freddie.  That is what they did with the 2012 sweep agreement.  All residual cash goes to the taxpayers’ senior preferred shares.  The other common and preferred shareholders get nothing.   

The judge on September 30, 2014, ruled that only by overturning the HERA law can the hedge funds see a dime.  Since the sweep agreement was enacted with the consent of the Obama administration, any Congressional action would have to overcome a veto.  Yet, Congress is not known for action.  A law that would line the pockets of billionaires while ballooning the budget deficit and weakening the mortgage system in the U.S. might not be that easy to pass.  That being said, there is some dim hope that the constitutional challenge brought by Bill Ackman’s Pershing Square and others may succeed.   I think activist shareholders like Bill Ackman can do a lot of good for the economy and shareholders.   This is one case where the activists and their investors got their clocks cleaned.  In theory, legal judgments give uncorrelated returns, but, in this case, on October 1, 2014, the returns are correlated with the market and are all negative.

  FNMA and FMCC trade over the counter and are as such very risky stocks.  Neither I nor Oxriver Capital have any positions in FNMA and FMCC. 

Mean reversion is one of the most powerful forces in all of finance. Above average performance is eventually followed by below average performance. Good times can lead to bad times and the best time to invest is during the bad times.

But this concept is generally reserved for the broader markets, not individual stocks. The problem with ‘buy when there’s blood in the streets’ is that sometimes individual stocks don’t comes back from the dead.

Although the market was spitting out tons of value during the financial crisis, not everything available at fire-sale prices worked out. I remember a portfolio manager friend of mine told me he was buying American International Group (AIG) hand over fist when it hit a few bucks a share. “All it has to do is come back half way to the prior peak and I’ll be rich.”

You can see this strategy didn’t work out that well:

The same thing happened to a number of well-know financial stocks, including Bank of America (BAC):

Citigroup (C):

And Fannie Mae (FNMA):

One of the most common behavioral biases when buying individual stocks is anchoring to previous levels or the purchase price of a stock. The first thing investors do when researching a stock is pull up a historical chart of past prices. The fact that a company traded for a certain price in the past gives investors a false sense of hope that it will automatically go back to that previous price point. Sometimes this works, but trying to catch a falling knife can be a dangerous strategy if you don’t know what your’re doing.

My friend Michael Batnick shared some great statistics on individual stocks a couple of weeks ago that puts this into perspective from the standpoint of the overall market:

Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value.Looking at the table below, we see that nearly sixty percent of Tech companies have had a catastrophic loss, which they define as “a 70% decline from peak value with minimal recovery.”

Averaging down in a losing stock sounds like a great strategy in theory. And it is, assuming you have a good idea about the future prospects of the business in question and are fairly certain the market is undervaluing the company. Stating the obvious, this is not an easy task.

Be fearful when others are greedy but make sure you understand what you’re buying into.

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.

No Evidence of Froth In Penny Stocks

There is certainly no shortage of excessive behavior in the financial markets right now, from equity valuations, allocations and sentiment to corporate behavior pertaining to IPO's, M&A, debt issuance, etc. One area, however, conspicuously absent from this excessive behavior is one that in many ways is the embodiment of speculative excess: penny stocks. Transactions in these stocks during the month of July totaled just 219,305, according to OTC Bulletin Board. This was the 3rd lowest figure since 1996, behind only two months in 2012. That is not the type of behavior one would expect at a cyclical market top.

For reference, in March of 2000, transactions in penny stocks totaled over 5 million. We did not include it on the chart as it distorts the scale. That is frothy, speculative behavior. The 2007 top did not experience that type of froth but penny stock activity was considerably higher than it is currently. The peak during that cycle occurred in March of 2006 at over 1.7 million transactions but for much of 2006 and 2007, monthly transactions remained over 1 million. That mark has only been reached during 1 month since, in March of this year. It would be tough to make the argument that penny stock activity reached an excessive level based on that one month, particularly since it has retreated to near 18-year lows now.

Incidentally, using transaction volume seems to more accurately reflect collective investor sentiment than share volume or dollar volume. At times, share and dollar volume has been distorted by heavy activity in one particular stock, like FNMA this past year.

Mortgage financier Federal National Mortgage Association (OTCBB:FNMA) turned in a record profit of $58.7 billion for the March quarter, indicating optimistic times for the housing sector ahead.

The bounce-back by the company, which was caught bang in the centre of the mortgage crisis in 2008, has surprised many as it was the recipient of one of the most expensive bailouts that corporate America saw.

There is no doubt that demand for housing has been rising over the past one year and while it may not have reached the heights it did before the sub-prime mortgage crisis, it is nevertheless buoyant.

Prices are rising at the fastest rate since the housing bubble burst and banks, chastened by their previous losses, are making sure that they are ending only to qualified buyers.

Between them, Fannie Mae and Freddie Mac own or guarantee nearly half of all U.S. mortgages while backing nearly 90 percent of all new ones.

Of the total profits it earned, Fannie Mae said that about $51 billion came in part from using the tax credits. That followed $17.2 billion in profit earned last year. And Fannie says it expects to stay profitable for “the foreseeable future.”

Most of the money that the company has earned will go back to the government, as per an agreement when it was rescued by the government.

Under a federal policy adopted last summer, Fannie and Freddie must turn over their entire net worth above $3 billion in each quarter to the Treasury. Fannie said its net worth in the first quarter was $62.4 billion.

Fannie will pay a dividend of $59.4 billion to the U.S. Treasury next month. Once that’s paid, Fannie will have repaid $95 billion of the roughly $116 billion it received.