Did you see Michael Lewis on 60 Minutes Sunday night? He was there to promote his new book, The Big Short: Inside the Doomsday Machine.
Lewis is a great writer, one of the best around. His books Moneyball and The Blind Side are two of the most enjoyable things I've read in the last several years. Aside from great storytelling, his books also show he knows a good idea when he sees one...
But nobody's perfect. On 60 Minutes, Lewis made the same mistake as everyone else, glossing over the fact that the financial crisis couldn't have happened if the U.S. financial services industry weren't the most heavily regulated industry on Earth. And like everyone else, Lewis complained about the "unregulated" credit default swap (CDS) market. CDSs are essentially insurance policies on bonds. They're cheap for safe bonds and expensive for riskier ones.
Like everyone else, Lewis ignored the fact that the CDS market is private only because the Commodity Futures Modernization Act made it that way. It was regulated underground. Without the CFMA, a transparent public futures market in CDSs could have formed and was, in fact, being discussed before the law put the kibosh on it. Everybody and his brother would have seen prices on CDSs for Lehman Brothers and AIG rising during the summer of 2008, harbingers of impending doom, way ahead of the ratings agencies.
What's more, banks sold prime mortgage loans and bought "triple-A-rated" collateralized debt obligations (CDOs) only because the Basel II Capital Accords established lower capital requirements for triple-A-rated securities than for prime mortgage loans. When capital requirements drop, you suddenly have more money you can spend on other things. Basel II made the ratings agencies instantly more powerful and important to a bank's competitive position than the behavior of its own underwriters.
Throw in the Community Reinvestment Act, two ill-managed massive entities making markets in mortgages (Fannie and Freddie), and the Federal Reserve – a government-created private banking cartel – and you have a government-led financial disaster.
There's plenty of blame to go around, I know. But how anyone could miss the massive role of the misguided, heavy-handed regulation is beyond me. Everyone who ought to know better – from hedge-fund managers to our elected representatives – says we need more regulation, not less.
Isn't that curious? The solution is never less regulation, and the fault is never too much regulation. If I were more paranoid, I'd cry conspiracy.
It might not be a conspiracy, but there is a media blackout on this subject. Nobody says CDSs were regulated underground, delivering an oligopoly to JPMorganChase, Bank of America, and Citigroup. They were the only firms with enough scale to handle the expensive task of contacting counterparties, producing contracts, and a thousand other expensive things necessary to create a large private market in CDSs. Pushing CDSs underground concentrated risk in big financial institutions (you know, the ones that blew up all at once a year and a half ago?), instead of diversifying risk via a broad, open, liquid trading market.
The ultimate irony of our overregulated financial system came across the newswires yesterday. One story said a new law was being unveiled that would "force the [financial] industry to pay for its failures."
The only reason the industry isn't paying for its failures is the government interfered and staged the biggest bailout in history! The government creates a problem, and the solution is somehow always... more government.
The greatest investors alive are well aware of the government's enormous role in propping up our financial system. And they aim to get their share of the spoils by owning financial stocks.
John Paulson, the $3 billion man, has a big stake in Bank of America, as do several other hedge funds, including Third Point, Lone Pine Capital, and Viking Capital. Eddie Lampert and Carl Icahn are among at least half a dozen hedge funds with stakes in distressed small-business lender CIT Group. Looking through 13F filings yesterday, I saw several firms holding JPMorganChase and Wells Fargo, both "too big to fail," just like Bank of America.
Big financials are also good inflation plays. This might not seem right, since they're holding dollars and the dollar's value declines during inflation. But inflation means more dollars in circulation... more dollars in banks... and more dollars to lend and charge fees on. And who gets the new money first? Banks do, of course. It comes to them through the Federal Reserve in the form of low-interest loans and reserve-boosting activity by the Fed. Don't forget a counterfeiter spends his new money first and gets the full benefit of it, before the rest of society figures it out and raises prices... just like banks.
A bunch of financial businesses ought to benefit from taking in higher-value dollars today and paying out lower-value dollars in the future. Life insurance companies are a great bet on that. By the time they pay out the dollars they take in, those dollars will be worth quite a bit less. Meantime, they can invest and earn a return on them. Billionaire vulture investor Wilbur Ross thinks life insurance companies are cheap and attractive today.
I've got life insurance stocks on my radar, too, along with oil & gas and defense. Like James Montier says in his excellent book, Value Investing: Tools & Techniques for Intelligent Investment, you have to be top down and bottom up. And these days, top down means thinking about the influence of government before you invest.
I thought about all this before I recommended Automatic Data Processing in Extreme Value as the financial crisis raged in October 2008. ADP processes one-sixth of the country's paychecks. And it holds on to your tax money before forwarding it to the federal government. About one-third of its income is interest earned on that "float." As interest rates rise and the world demands higher compensation for holding U.S. dollars, ADP becomes much more profitable without adding another penny of capital expenditure or a single new employee. ADP has raised its dividend every year for 33 years in a row, one of the all-time great income stocks. It's trading for more than my maximum buy price these days, but Extreme Value readers who took my advice made an easy 41%.
I've got another great play on the overregulation of our financial system and the effects it can have on natural resources markets. Extreme Value readers are already up 40% in one year, but the company's intrinsic value has doubled since I recommended it, so I've raised my maximum buy price. Shareholders who got in years ago made 28 times their money. I think the next several years could wind up producing a similar result, with relatively little risk. It's selling for less than its cash and investments, and is easily one of the best small-cap stocks you've never heard of. For details on Extreme Value, click here.
Fairholme Fund's Bruce Berkowitz, who was recently named Morningstar's fund manager of the decade, is buying financials, too, including a "significant" position in AIG. Berkowitz's mutual funds and managed accounts own more than 13 million shares of the battered insurer and "hundreds of millions of dollars of the debt." Berkowitz started buying AIG in the second half of 2009 as he saw AIG's cash flows turn positive... "It is still a good company with a good global brand."
AIG's stocks and bonds rallied after the company sold its two biggest non-U.S. insurance divisions for a combined $51 billion. But the company still owes more than $40 billion to the Treasury and around $25 billion on a Federal Reserve credit line. Berkowitz doesn't care. He's buying shares of a company that have gone from bad to less bad. And he expects to be a long-term shareholder because "it is going to take some time for AIG to fully recover."
Berkowitz fails to mention the largest margin of safety for his AIG positions... The U.S. government owns some 80% of the insurer. And it is wont to recover its nearly $200 billion "investment" in AIG.
AIG is Berkowitz's second large position in a wrecked financial behemoth. As we've previously mentioned, he also bought more than $700 million worth of Citi shares. Berkowitz recently told Fortune even Citi's bad assets are returning more than 5% now... "People are so focused on the liabilities that they've potentially forgotten about some of the assets." Berkowitz also notes Citi's Tier 1 capital ratio of 11.7% and the fact that shares are trading at 0.8 times tangible book value (almost half the ratio of its peers). "The price is right," Berkowitz says. "It's just a question of when it becomes obvious to everyone that the worst is over."
The always up-to-the-minute credit ratings agency Moody's released a note yesterday saying the U.S.'s triple-A rating could be in danger. Moody's said the U.S., along with Britain, has moved "substantially" closer to losing its top rating. For now, the country's triple-A rating is "stable," but its "distance-to-downgrade has in all cases substantially diminished." Never mind China and the rest of the world dumping U.S. Treasuries. We'll know the U.S. is really in trouble when Moody's downgrades the debt.
New highs: Hershey (HSY), McDonald's (MCD), Wal-Mart (WMT), Enterprise Partners (EPD), Automatic Data Processing (ADP), Steak 'n Shake (SNS), A. Schulman (SHLM).
The mailbag's a little light today... so we resort to publishing bizarre spam messages... Please, please rescue us from that fate: feedback@stansberryresearch.com.
"I'm sorry for this odd request because it might get to you too urgent but it's because of the situation of things right now.
"I'm stuck in London, England with my family right now, we came down here for a short vacation then i was robbed, worse of it is that bags, cash and cards and my cell phone was stolen at GUN POINT, it's such a crazy experience for us, we need help flying back home, the authorities are not being 100% supportive but the good thing is we still have our passports and return tickets but currently having troubles paying off the hotel bills and also getting a cab to take us to the airport.
"I need you to loan me some money and i promise to pay back tomorrow.. You have my word!!" – Random spammer Donna Bloniarz
Ferris comment: I've gotten a few similar e-mails over the past couple weeks. It seems to be some sort of running joke I don't get. I think that happens when you get old. Everyone's laughing but you either didn't hear it or you can only understand it if you were born after the iPod was invented.
Regards,
Dan Ferris and Sean Goldsmith
Medford, Oregon and Baltimore, Maryland
March 16, 2010Lewis on 60 Minutes... What nobody's saying about CDSs... How Basel II lowered credit standards... Mega investors gobbling up financials... "The best small-cap stock you've never heard of"... Berkowitz buying AIG and Citi... Moody's is late to the party (again!)...