A Brief History of (Financial) Toxic Waste

One of the glories of modern finance... The devil's best trick... A brief history of (financial) toxic waste... $16 trillion of negative-yielding debt... Three ways to protect yourself from what's coming next...

It's easier to turn a safe asset into toxic waste than it is a risky one...

I (Dan Ferris) learned that from studying the history of market crashes and speculative episodes.

One theme crops up time and again... In almost every generation, you can find some genius on Wall Street who took an investment vehicle previously seen as boring and conservative... and turned it into leveraged pile of toxic waste.

Almost like clockwork... every 10 years or so... bankers, governments, and investors make the same dumb mistake and learn the same painful lesson.

I'm not talking about risky investments like miners, biotech, or brand-new companies touting new technologies like 3-D printing, electric cars, and vegetable-based meat substitutes.

Most folks already know those things are risky. So it's hard to convince a large enough number of investors that they're safe to really cause some serious financial damage.

If you want to wipe out trillions of dollars and screw millions of people – including those with no investment capital at risk in the newly toxified asset – you need to start with an investment vehicle widely viewed as safe and boring...

Like the U.S. 30-year fixed-rate mortgage.

The U.S. 30-year fixed-rate mortgage is the one of the glories of modern finance...

It provides an investor with three decades of steady income at a fixed rate. It's secured by real property in one of the richest countries in the world, one that also respects the rule of law and property rights. (That's less common than you might imagine, as economist Hernando de Soto explains in his book, The Mystery of Capital.)

Many U.S. mortgages carry an implicit government guarantee by conforming to Federal Housing Finance Agency loan limits and meeting funding criteria of Freddie Mac and Fannie Mae. Those are known as "prime" mortgages to high-quality borrowers with good jobs and plenty of collateral.

Perhaps best of all, safe as it is, the 30-year mortgage provides a greater yield than similar-dated U.S. Treasury bonds. With 30-year bonds yielding a little more than 2% today, the SPDR Bloomberg Barclays Mortgage Backed Bond Fund (MBG) – which invests in those higher-quality Fannie/Freddie conforming loans – currently yields 3.35%.

Mortgage-backed securities have been around since the 1980s. They were mostly a boring proposition...

Until Wall Street saw an opportunity to make money by turning them into toxic waste.

How did they do that, you ask?

By changing virtually every feature of the 30-year fixed-rate prime mortgage, slicing and dicing them, adding leverage here and there, and convincing the world they were still AAA-rated securities.

Fixed rates were changed to adjustable rates, which would rise and fall with benchmark interest rates. Prime loans to high-quality borrowers gave way to subprime loans to low-quality borrowers – some of whom had no income, no job, and no assets (so-called "NINJA loans").

The devil's best trick is convincing you he doesn't exist...

The bankers did a similar trick: They lent money to people who couldn't pay it back, then convinced investors they were safe as houses – an expression whose irony still hangs heavy in the air 10 years after the bottom of the housing crisis.

The Fed had pushed interest rates down to combat the tech bubble meltdown of 2000 to 2002, and investors were starved for yields. So the banks lent money to anybody who could fog a mirror, sprinkling toxic waste around like poisonous fairy dust. The U.S. financial machine issued more than $16.3 trillion of mortgage-related securities from 2002 to 2007, roughly two and half times the amount issued in the preceding six years.

Wall Street sliced them and diced them into weird instruments called collateralized debt obligations ("CDOs") and "CDOs-squared." Don't bother asking what the heck is in them. To understand a typical CDO, an investor would have to read 15,000 pages of documentation. To understand a CDO-squared, he'd have to read 750,000 pages (no typo). As Warren Buffett said in 2010, "It can't be done."

Ratings agencies, ever on the hunt for more fee revenue, sealed their noses tight with industrial-strength clothespins and applied their highest rating – AAA – to the newly minted toxic waste. It was as if the Red Cross offered free vaccines and instead injected us all with the Black Plague.

Wall Street banks were able to sell, sell, sell them on the presumption that U.S. housing prices would never fall again, since they hadn't fallen in way too long for anybody to remember.

You know what happened next...

Housing prices started falling.

Leveraged mortgage funds at venerable institutions like 85-year-old Bear Stearns imploded.

Then, the whole thing collapsed, leading to the failure and bankruptcy of 158-year-old Lehman Brothers... the failure and bankruptcy of 119-year-old Washington Mutual... and the failure and bailout of then 89-year-old AIG.

Ultimately, more than 300 banks failed during what we now call the Great Recession, from December 2007 through June 2009.

Let me ask you this...

If Wall Street tried this with mining stocks, could it have gotten anywhere near that far? Could it ever convince large swaths of population that mining stocks were the safest thing in the world, then issue more than $16 trillion worth of securities based on them?

That'd be impossible. I doubt much more than about $1 trillion of mining equities is trading in the world today. It couldn't be done.

No, to bamboozle the greatest number of investors, you need massive financial innovation to occur.

Like what happened with investment trusts in the 1920s...

The investment trust was a conservative vehicle, as the name implied...

Scottish investor Robert Fleming and other investors formed the first Scottish trust in 1873, an early success story imitated by others in the U.K. Fleming became the premier figure in the asset-management industry in the last 25 years of the 19th century. He garnered an enviable track record, based on dogged research, including 64 monthlong round trips to America to do investment research over a 50-year period.

In his book, The Origins of Asset Management From 1700 to 1960, historian Nigel Edward Morecroft says...

[Fleming and his team created] a sustainable approach, built on hard work, attention to detail, low fees, and an optimistic view of the financial markets and the fledgling economy in the USA, which helped to turn asset management into a high-quality, professional activity.

Trusts in the U.S. through the early 20th century were handled by the archetypal "Yankee trustee," described by John Brooks in his classic work, The Go-Go Years: "Trusteeship is by its nature conservative – its primary purpose being to conserve capital – and so indeed was the type of man it attracted in Boston." (The country's financial center until after the Civil War.)

In his book, The Great Crash 1929, John Kenneth Galbraith described the early trusts this way: "The smaller risk and better information [gathered by its managers] well justified the modest compensation of those who managed the enterprise."

But by the late 1920s, Wall Street bankers had hijacked the Yankee trustees' conservative posture. By 1929, writes Galbraith, "One referred to high-leverage trusts, low-leverage trusts, or trusts without any leverage at all."

It didn't end there...

Galbraith writes of a typical leveraged trust whose assets increased 50%, but whose value increased 125% due to leverage. "Were the stock of that trust... held by still another trust with similar leverage, the common stock of that trust would get an increase of between 700% and 800% from the original 50% advance."

Before the 1920s mania, few trusts existed on this side of the Atlantic. By the beginning of 1927, there were 160. Another 140 came into being that year. An estimated 186 investment trusts were formed in 1928. By early 1929, they were coming into existence at roughly one per business day. From early 1929 through fall 1929, total investment trust assets increased elevenfold. They were issued by the likes of JPMorgan and Goldman Sachs.

The aftermath was what you'd expect, and its essence was captured by Galbraith, who quoted a snippet of Samuel Sachs' (of Goldman Sachs) testimony before Congress after the crash had decimated investors and obliterated the trusts...

Senator [James] Couzens: Did Goldman, Sachs and Company organize the Goldman Sachs Trading Corporation?

Mr. Sachs: Yes, sir.

Senator Couzens: And it sold its stock to the public?

Mr. Sachs: A portion of it. The firm invested originally in 10% of the entire issue for the sum of $10 million.

Senator Couzens: And the other 90% was sold to the public?

Mr. Sachs: Yes, sir.

Senator Couzens: At what price?

Mr. Sachs: At $104. That is the old stock... the stock was split two for one.

Senator Couzens: And what is the price of the stock now?

Mr. Sachs: Approximately [$1.75].

The trusts of the 1920s and the mortgage-backed securities of the housing bubble era are perhaps the best examples of Wall Street's ability to turn conservative investments into pure toxic waste.

But there's another example happening today. And you don't need to look hard to find it...

Right now, more than $16 trillion worth of bonds are trading around the world at negative yields...

Most of them are sovereign bonds of European countries and Japan. All Swiss bonds, including its 50-year issue, trade currently at negative yields.

If you buy a bond at a negative yield, you're guaranteed to lose money if you hold it to maturity. Never mind the various scenarios under which institutions of various types are required to own them.

Sovereign bonds of developed nations – of Switzerland, for Pete's sake! – are supposed to be some of the safest, most conservative assets in the world. This is the stuff rich people buy. They have plenty of money and aren't so worried about making a lot more, but want to protect what they have.

And this time, you can't really blame the con artists on Wall Street. This time, the central bankers and their armies of formula-wielding economists are to blame.

I bet negative interest rates will go down in history as worse than the investment trusts... worse the than the CDOs... worse than anything before them.

The central bankers have meddled with the primal forces of nature. They have obliterated and corrupted the time value of money. How they expect that to lead to increased investment and economic growth is anybody's guess.

They've made it nearly impossible to value any asset that generates cash flow without pretending that interest rates are higher than they really are today. I don't want to get too technical here, but you can't value something that generates a cash flow – things like buildings, bonds, or operating businesses – without reference to some benchmark interest rate.

I know you're asking, 'How does this all end? What can I do about it?'

I don't know the future, but I have a couple of suggestions...

First, you'll want to own the shorter end of the yield curve.

Two- and 10-year Treasurys yield about the same today. But if you believe as I do that the Federal Reserve's 25-basis-point (0.25%) rate cut last month was the first of several, then it's a pretty good bet that the short-term yields will fall dramatically.

Find yourself an exchange-traded fund that buys Treasurys of maturities of two years or less and park some cash there. You could start by looking into the iShares 1-3 Year Treasury Bond Fund (SHY) and the Vanguard Short-Term Treasury Fund (VGSH).

Second, you should seriously consider learning all you can about value investing.

It's about to come strongly back into vogue with a vengeance. I've said that at length in previous Digests, but the simple truth is that value stocks have underperformed for most of the last 10 years. That can't (and absolutely won't) last forever. Bone up on value investing now... while you still can.

Third: Gold, gold, gold.

When yields evaporate, governments (like the U.S.) enact protectionist measures. And the answer to almost every (made-up, nonexistent) societal ills is: "Steal more from productive people and give it to everybody else."

That means you want to get your money outside the financial system. And that's gold (and silver). Two of the three gold-related recommendations in my Extreme Value service are trading at dirt-cheap prices. I doubt that'll last long.

I've consistently given this same advice for about two years now...

For quite a while, it looked like I was crying in the wilderness. Today, it looks like I was reading headlines from two years in the future. Expect more of the same and prepare accordingly.

And believe me, when my outlook changes, my Extreme Value subscribers will be the first to find out... After that, I'll let the rest of you know it here in the Digest.

One more thing...

I'd be remiss if I didn't also remind you that legendary gold analyst John Doody has officially joined the Stansberry Research team. When it comes to investing in gold-mining stocks, no one has a better long-term track record than John.

Over the last 20 years, his recommendations have outperformed gold, major gold funds, and even the broad stock market. In fact, they've more than tripled the return of the S&P 500 over that time... and he has the audited results to prove it.

Even Jim Grant – publisher of the famed Grant's Interest Rate Observer and longtime proponent of gold ownership – has called John an "authority" on the sector.

In short, if you're even thinking about investing in gold stocks, you owe it to yourself to know what John is thinking. And tomorrow night, he'll be joining my colleague Steve Sjuggerud for a special event...

During this event, John will explain how his unique gold stock strategy could help you make a fortune in the current bull market. He'll also share the name and ticker symbol of one little-known gold investment that he believes could soar 500% or more in the coming months. And you'll even have the chance to win up to $20,000 worth of beautiful MS64 Saint-Gaudens gold coins, just for attending.

This event is absolutely free for all interested Stansberry Research subscribers. Just click here to reserve your spot.

New 52-week highs (as of 8/19/19): Axis Capital (AXS), Booz Allen Hamilton (BAH), General Mills (GIS), Hershey (HSY), Coca-Cola (KO), Lockheed Martin (LMT), Medtronic (MDT), Nestlé (NSRGY), Nuveen Municipal Value Fund (NUV), ResMed (RMD), AT&T (T), Vanguard Real Estate Fund (VNQ), W.R. Berkley (WRB), Aqua America (WTR), and short position in Advance Auto Parts (AAP).

What do you think of today's Digest? Let us know at feedback@stansberryresearch.com.

Regards,

Dan Ferris
Vancouver, Washington
August 20, 2019