One-Day Panics Often Point to Quick Profits

"This is the end"... Our fraudulent banking system... It's no 'land of the free'... Half our banks gone in five years... FDIC: fraud... Greenberg begs for a bailout... The next failure: WaMu or Goldman?... A short-term bottom...

Could this be it? Could this at long last be the beginning of the end of our fraudulent, insolvent, fractional reserve banking system? One can only hope. If it's not the end, it certainly deserves to be the end.

Fraud is everywhere in American finance, and it's all rooted in the pervasive interference of government in our financial system. Not that anyone is saying this anywhere in the financial press. The consensus seems to be more interference is called for, and, in the words of well-known short seller and dim bulb Doug Kass, "Laissez-faire has failed."

I don't know what country you live in, Doug. But I was born in 1961, and I've never seen a free market for any good or service in the United States in my life. This might be the home of the brave, but it hasn't been the land of the free for a long, long time. Regulations and interference got us here. They won't get us out.

Just one more example of the fraud the government rams down your throat every day: Do you honestly expect me to believe that, during the biggest credit crisis in our history, it's normal to be able to borrow money for 10 years and pay less than 3.4%? Well, the 10-year Treasury note is yielding 3.398% as I write this. Would a free market come up with that? Don't insult my intelligence.

If this is such a free market, why was I sitting there this morning waiting for the chief counterfeiter, the Federal Reserve, to emerge from its secret meeting and tell us whether it'll cut interest rates.

We're slaves to these overeducated elitist morons. They think they control the economy. And to the extent we're complicit, we aid and abet the open sabotage of our own money. Wall Street is certainly complicit. When the Fed announced it wasn't cutting rates today, equity traders on the NYSE floor booed and said, "We want a bridge loan for AIG!"

You want to avoid this kind of crap? It's easy. Abolish the Federal Reserve right now. That would go a long, long way toward preventing this from happening again. But don't embarrass yourself by telling everyone in the land of 10,000 laws we don't have enough government involvement. And don't ask me what I'd put in place of the current regulatory scheme, either. What do you put in place of a cancer?

Want to see some more fraud? Take a look at the Federal Deposit Insurance Corporation. The FDIC's reserves took a 14% hit this summer when IndyMac and five other banks failed over a seven-week period beginning July 11.

FDIC chairman Sheila Bair says the FDIC will be fine and won't have to tap its $30 billion line of credit with the Treasury. I don't believe her, though I believe she's incompetent, not a liar.

Deposit insurance is pure fraud. Fractional reserve banks are inherently insolvent and therefore uninsurable. Under the U.S. fractional-reserve system, a bank's reserves equal only 10% of deposits, by law. So there's no way any bank in the country could survive a deposit run. The money isn't there. It's been lent out. Check out Murray Rothbard's The Case Against The Fed, under the subhead "Deposit Insurance," for more on this all-important topic.

Yesterday, billionaire distressed investor Wilbur Ross said he thinks 1,000 banks will fail as the credit crisis sweeps across the country. I've been saying something like that since April, though I've said "hundreds," not 1,000.

Yesterday, Bank of America CEO Ken Lewis told an interviewer he thought there might be half as many banks in the U.S. five years from now, down from the current 9,000... though he was talking about consolidation, not failures.

Ken Lewis also said, "I don't know of a major bank that doesn't have significant exposure to AIG." The insurance giant's stock tumbled 86% in four days as the company announced it needs at least $40 billion in cash (some say it needs at least $75 billion) to stay afloat.

AIG's problems stem from a division focused on complex debt securities and derivatives. The company was recently downgraded by Standard & Poor's and Moody's, and now has to return billions of dollars to the "counterparties" (every major bank in the world) in its derivative trades.

This morning, former AIG Chairman and CEO Hank Greenberg said of a possible bridge loan from the Fed, "It's not a gift. It's not a bailout, because it's a solvent company." I'm curious to see how Greenberg's definition of solvency might differ from the market's.

Greenberg also practically begged the ratings agencies to give AIG more time. The talk is that AIG is not insolvent, just illiquid. Bill Gross said it again this afternoon.

Gee, that's funny. Merrill Lynch didn't have any trouble liquidating its distressed assets earlier this year. They sold for 22 cents on the dollar. No illiquidity there. That's the reality companies like AIG don't want to face: 22 cents on the dollar. No bailout. No market failure. No additional regulation required. Just good ol' fashioned price discovery in a negotiated transaction.

That's what financial markets do. When you buy garbage with leverage, the market is supposed to punish you. The market hasn't failed at all. It's working brilliantly. When you sell this crap, you're supposed to take it on the chin. Whether you're solvent or liquid after that is nobody's business but you and your counterparties and investors. All this whining and calling for backstops and bailouts is just a bunch of busted gamblers praying for a miracle.

Yesterday, trading guru Dennis Gartman told investors to get small, meaning hold cash and wait for the smoke to clear. Gartman says he has a couple small positions in banks, and a large position... in 12% Letter pick McDonald's, which rose yesterday and today. Apparently, credit crises don't hurt the demand for cheeseburgers and french fries. My own demand for these items has remained intact. If it weren't for the treadmill and the dog, I'd weigh 250 pounds.

This morning, I heard one talking head say, "There's a difference between what I'm willing to do and the advice I'm willing to give others." Wow. And you think Stansberry is full of it? Then again, saying S&A treats you better than CNBC is like saying a sizzling $50 steakhouse filet tastes better than a cold Whopper.

Rumor has it British bank Barclays is back at the negotiating table with Lehman Brothers. A deal should be announced today. Barclays previously held talks with Lehman, but walked away because the government wouldn't guarantee $85 billion of risky assets on Lehman's balance sheet – the same deal JPMorgan received when it bought Bear Stearns. If Barclays buys Lehman, it'll spare Wall Street another 10,000 layoffs.

Bloomberg reports asset managers PIMCO, Vanguard, and Franklin Advisers will be among the biggest losers in the Lehman deal, facing at least $86 billion in losses. Mutual funds hold more than $143 billion in Lehman bonds, led by PIMCO. They will probably only recover 40% of their investment.

Want to know how risk takers ought to behave? Whitney Tilson passed along this Munger quote from Berkshire Hathaway's 2007 meeting... "We only write fire insurance on concrete bridges that are covered by water." Munger says the complex mathematical models smart people use to misprice big risks are "at least 50% twaddle." That's what Wall Street is: a giant twaddle distillery.

Who will be the next to fail? In the current issue of Extreme Value, I predict it'll be Washington Mutual, the largest U.S. savings and loan. WaMu had its credit ratings cut to junk due to its mortgage exposure and lack of capital. Its shares are down to $2 from $40 last year. Over half of WaMu's loans are in the riskiest categories: subprime, option ARMs, and home equity. I'm also not crazy about the thrift model, which is simply to gather low-quality deposits and other funding sources and lend, lend, lend.

Or maybe it'll be Goldman Sachs. If the bank's "creative accounting" doesn't take it down, its rapidly deteriorating business might. Goldman announced earnings today, and net income dropped 70% for the quarter. Investment banking revenues fell 40%, and financial advisory revenues fell 56%. Revenues in Goldman's trading and fixed-income business both fell 67%. Interestingly, the bank didn't attach a cash-flow statement to its filing. The cost of insuring Goldman bonds against default was up 5% earlier today, a big jump.

If Goldman fails, it would be bad, and perhaps more unexpected than any of the previous failures...

But if AIG fails, be ready to put everything you have into the markets. That'll be the mother of all failures, and I'd bet it would cause an enormous capitulation in stocks.

New highs: none.

In the mailbag: Where were you when you caught your first 10-bagger? Let us know: feedback@stansberryresearch.com.

"Talk is cheap. Derivatives caught these bastards red handed and destroyed them in the process. Call it what you want, they are 'off the books bets' playing w/ other people's money. Good ridance to them all including Merril Lynch. They have been cheating and lying their way through funds which, by the way, did not even belong to them. And if that isn't a wake up call for those who have any paper money to move them into gold and silver, I don't imagine anything will." – Paid-up subscriber Benjamin Franklin

Ferris comment: Agreed. Everyone forgets that all banks in a fractional reserve system are inherently insolvent. There's no telling how long it takes for such a system to collapse. But when it does, you'd better own some gold.

Another thing to remember: The Federal Reserve has a monopoly on money creation. It can't go bankrupt. Rather than go bankrupt, it will just create more checkbook money out of thin air. That's the source, the inflationary spigot. That's why I've been telling everyone they must own some gold. I should append that. Own gold and silver. If you haven't bought some yet, do it today.

"Well, today was my day for a 10 bagger, the first time it has happened to me, hopefully not the last. I owe it all to Dan Ferris for bringing the Lehman short to my awareness and to Jeff Clark for giving me the confidence/knowledge and experience to buy put options. I made over 20k in several of my accounts today, I figure this will take care of my Alliance Membership dues, with a little bit extra leftover... Thank you all for your sound financial counsel. Here's hoping this 50 year old, with not much in savings – due to a late in life decision to go to medical school, will be able to accumulate enough so that I will be your neighbor in Rancho Santana." – Paid-up subscriber BB Gregory

Ferris comment: Actually, you owe it to yourself. You're the one who pulled the trigger. I'm glad Lehman worked out for you.

"Porter, Even if I wanted to reject, or hide from, your politcal rants, I would peep through the curtain to catch Jeff Clarks option plays... my goodness, that man has talent. I have made some serious bucks with his picks, thanks Jeff, keep 'em comin'!!!" – Paid-up subscriber Jim

Ferris comment: Thanks, Jim. I'll pass it along to Jeff. If the rest of you want to see what the fuss is about, click here.

Regards,

Dan Ferris

Medford, Oregon

September 16, 2008

One-Day Panics Often Point to Quick Profits

By Ian Davis

Nothing panics Wall Street quite like the failure of an investment bank. And over the weekend, we saw two:

Lehman Brothers declared bankruptcy, and Bank of America bought Merrill Lynch. This is after Merrill Lynch stocks plummeted 78% in one year.

These two tremendous shocks scared investors. On Monday, the Dow Jones Industrial Average fell 4.4%, or 504 points. That's the index's largest single-day point loss since the aftermath of 9/11.

And the Dow has fallen by that much (or more) on a percentage basis only 15 times in the last 58 years...

Large Declines Occur Near Market Bottoms

It is a little hard to see on a chart with such a long time frame, but many of the previous large declines marked at least a short-term bottom for the market.

The Friday before "Black Monday" (October 19, 1987) was one notable exception. On Friday, October 16, the Dow fell 108 points (4.6%). If you'd bought at Friday's close, you were invested during the worst of the panic. The next Monday, the Dow fell 22%.

Here are some statistics on the Dow's performance following each of the 15 extreme down days.

The most interesting thing about the above table is the performance of the Dow over the medium term.

Three months after these down days, the Dow Jones Industrial Average was down only once. If you had bought the Dow on the close the Friday before Black Monday, you would have been down 14.7% three months later.

On every other occasion, you would have been up. The average three-month gain of the winning trades was a nice 9.6%.

However, these extreme down days do not necessarily coincide with long-term bottoms. After 12 months, the Dow was up only two-thirds of the time.

Also, the previous bear market (between 2000 and 2003) had four down days. If you had bought after those days and held for a year, you would have lost money three of the four times.

It's hard to know how the current bear market will play out. I would avoid the financials for now... But if you're interested in picking up some blue-chip stocks or an index fund for a short-term trade, now would be a good time.

Remember, this is probably only a short-term bottom. Don't hold your position for longer than three months.

Good investing,

Ian Davis

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