Big Bets Gone Bad

"Don't push two pair too hard." -- My father's favorite poker advice

It appears that some financial firms pushed their two pair too hard.

I am amazed at the destruction caused by the rise and fall of the housing bubble. No one has been immune, and the declines are staggering. No, sickening! Don't read the table below if you have a weak stomach.

Company

High

Recent

Decline

Fremont General

$48.52

$0.06

99.9%

IndyMac

$30.60

$0.16

99.5%

Bear Stearns*

$169.43

$9.33

94.5%

Freddie Mac (NYSE: FRE  )

$72.49

$0.46

99.4%

Fannie Mae (NYSE: FNM  )

$86.75

$0.70

99.2%

Lehman Brothers (NYSE: LEH  )

$82.83

$0.26

99.7%

Data supplied by Capital IQ, a division of Standard & Poor's; *Recent price for Bear Stearns is from May 30, 2008, before it was purchased by JPMorgan Chase (NYSE: JPM  ) .

And what about AIG (NYSE: AIG  ) or Merrill Lynch (NYSE: MER  ) ? On Thursday night, I posed the following question to my pod of Fools. "What are the chances Merrill will be a stand-alone entity one year from now?"

The six Fools who voted gave it a 70% chance. We sure blew that one!

Let's play guess the bubble
We humans are funny creatures. We tend to repeat the same mistakes over and over, rarely learning from them and usually rationalizing, "This time it's different."

Below is the description of a bubble from the history books. See if you can guess which bubble:

  1. A money-making idea is born.
  2. The idea is sold to investors.
  3. The government backs the idea and the price of those investments takes off.
  4. Others see "easy money" being made and demand a slice of the pie.
  5. Lather, rinse, repeat, and sell it to everyone who will buy.
  6. Dismiss outsider warnings because they're not good for business.
  7. What? The underlying assets cannot support the value of the investments?
  8. Investors rush for the exits.
  9. The bubble bursts.

Does this describe the junk bond bubble? The savings-and-loan bubble? The recent housing bubble? Actually, it's a general description of the Mississippi Stock bubble, which occurred in France in the early 1700s. Charles Mackay told its woeful tale in his book Extraordinary Popular Delusions and the Madness of Crowds.

In 300 years, the only thing we're good at is reacting to the crisis after the crisis is well underway. It's terrible that we can't prevent crises from happening until it's too late.

Break the cycle
I think the big lesson we can learn is that if it sounds too good to be true, then it probably is. Were housing prices going to increase at 15% to 20% per year forever to sustain the returns required on the crummy loans being made to people who couldn't afford them? Were there enough buyers to sell these crummy loans to, indefinitely? No. But lots of people didn't see an end. Because easy money was being made, no one was going to crash the party. As a result, they made what turned out to be very bad decisions and have caused the sale of antacids to increase tenfold.

Foolish takeaway
It's OK to make some riskier investments as a part of a diversified portfolio. But making highly leveraged bets on risky investments is a sure way to walk away from the poker table empty-handed.

David Meier is associate advisor for Million Dollar Portfolio. He owns some token shares of Fannie Mae and Freddie Mac but doesn't own any of the other companies mentioned. He is working on his poker face, though. JPMorgan is an Income Investor recommendation. The Motley Fool doesn't bet against its disclosure policy.


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