The S&A Digest: Get Ready to Buy Some Suffering Oil Refiners

Greenberg's memo from 1978... Beal says "beware"... Remember the 1970s... Cohen finally gets canned... Micks in the mailbag... Crack-spread indicator...

Alan "Ace" Greenberg, the legendary banker who built Bear Stearns into the fifth-largest Wall Street firm, was, like Warren Buffett, famous for his fastidious personal habits, his dislike of wasteful spending, and his memos. On October 5, 1978, shortly after he ascended to the CEO's office, he wrote a memo detailing the importance of staying in constant communication with the office, especially in times of crisis.

"It is absolutely essential for us to be able to talk to our partners at all times... I conducted a study of the 200 firms that have disappeared from Wall Street over the last few years, and I discovered that 62.349% went out of business because the important people did not leave word where they went when they left their desk if even for 10 minutes. That idiocy will not occur here."

Last summer, when Bear's mortgage positions began to crash, James Cayne (the CEO Ace Greenberg entrusted the firm to when he retired in 1995) was out of the office at a bridge tournament. And... last week, as clients began pulling their money out of the firm, setting off a spiral into bankruptcy, the current CEO, Alan Schwartz, was "out of pocket," according to the Wall Street Journal. Where was he? What was he doing? I'm sure Ace Greenberg will want to know.

As part of the Bear deal, the Fed agreed to buy $30 billion worth of mortgages. Does Bernanke have any real knowledge of what he's bought? Andy Beal, the contrarian banker from Texas, doesn't think so. Beal explains:

Many AAA mortgage bonds are actually extremely high risk because of little-considered nuances in the hundreds of pages of trust and indentures and servicing agreements... these contracts permit the loan servicers to advance payments on behalf of defaulted homeowners for years and years and years at interest rates of 12% and more... These 'servicer advances' are subsequently repaid FIRST from foreclosed home sales. Therefore, foreclosed home sales may result in little or no proceeds, or even a liability to the [owners of] AAA [mortgages].

This mechanism effectively transfers funds that really should belong to the AAA securities to the junior securities. Servicers that own junior securities are incredibly motivated to drag their feet resolving defaulted loans, which result in great loss to the AAA holders. This is not a misprint: Defaulted first mortgage home loans may become a net liability, not an asset, to some of the AAAs. This is still not widely understood.

Beal is right. And servicer advances aren't the only problems. I personally know a homeowner who hasn't paid his mortgage in over a year, but whose home hasn't been foreclosed because in the frenzy to issue the mortgage back in 2005, not all of the paper work got filed properly. And before the first mortgage was registered, a second mortgage was taken out. Inadvertently, the second mortgage became the first mortgage. Thus, to foreclose, the owners of the first mortgage will have to pay off the second mortgage.

Meanwhile, the now-junior first mortgage has been sold or transferred three times, to different mortgage companies, each of which has gone bankrupt. What's that junior-first mortgage worth today? After the legal fees and the expense of paying the second mortgage, probably a negative number. As a result, a $500,000 mortgage has become a net liability.

In June 1970, the sixth-largest enterprise in the United States and the largest railroad in the country, Penn Central, went broke. Like Bear Stearns, it lost the confidence of its lenders and it couldn't "roll over" its maturing short-term commercial paper loans. In short, its lines of credit were called in. As such, more than $200 million of notes couldn't be repaid.

Fear spread on Wall Street that other lines of credit would be pulled, triggering a chain reaction in the commercial paper market. There was $40 billion outstanding in the commercial paper market (real money, back then). How would it be repaid? The Federal Reserve stepped in, ordering its member banks to supply "liquidity" to the market. The printing presses ran night and day... and the inflation super cycle of the 1970s began in earnest. If you think we've had some inflation in our economy over the last five years, wait until you see what happens over the next five...

After swearing up and down that it did not have exposure to the mortgage mess, Goldman Sachs released earnings today and announced it had lost $1 billion on residential mortgages. Oops. Goldman's net income plunged 53%.

Goldman also announced it's finally parting ways with the grandmother of Wall Street, equity strategist Abby Cohen. Famously bullish for her entire career, she rode the bus from Brooklyn to Manhattan each day, wearing the same dumpy sweater and old-lady shoes. She apparently cared as little for finance as she did for fashion. At the start of her career as a strategist, at the end of 1998, the Nasdaq stood at 2,193. Today, almost a full 10 years later, the index sits at 2,177. For 10 years, tech stocks – the kind she greatly preferred – have done nothing, on balance. But that never stopped her from issuing absurdly bullish predictions. Did anyone ever take her seriously? We hope not.

Don't miss out on Dan Ferris' best idea right now... He's discovered how to get shares of one of the best-known companies in the world for free. His Extreme Value readers already received the report, but as loyal Digest readers, you should get a chance at the profits, too. You must act before 5:00 p.m. tomorrow. To learn more, click here...

New highs: CurrencyShares Japanese Yen (FXY), streetTRACKS Gold (GLD).

In the mailbag... we're moving on from prostitution, thankfully, I'm sure you'll agree. And... judging from the positive feedback we received about yesterday's Digest, most of our readers must be Irish... or at least willing to drink like a Mick on St. Paddy's Day. (For new readers, we've come to believe that only relatives or drunk subscribers would bother sending us anything positive.) Send your drunken ramblings here: feedback@stansberryresearch.com.

"...I really enjoy the daily Digest and especially look for your thoughts on days when the market has been a little crazy (there's been a number of those this year.) Thank you for you service and I trust you'll be educating and entertaining us for many years to come. As for my portfolio, I've probably done the best with Dr Sjug and the Med Investor last year but the Oil Report has also been good to me (and the Gold report). Thanks for all you do." – Paid-up subscriber John Musil

"Screw prostitution because this is the best Digest you ever did. Congrats, and I wish I were in Balmer. I'd take you all out for a fabulous dine time. I wrote on Friday to say keep up the good work you digest, and what a reward. My $6K has made me proud of you." – Paid-up subscriber Joe Cisar

"Is there a publication available in your group specifically designed to help us survive and take advantage of the looming national debt and entitlement crises coming in the next 5-10 years? If not will there be one? Or is there a way to use the present publications you have to accomplish that end?" – Paid-up subscriber Robert Nieman

Porter comment: We're putting together a special report on this very topic this week. It will be free to all lifetime and new auto-renew subscribers.

"Kudlow tonight mentioned that Congress passed legislation giving the Fed authority to lend to financial enitities such as Bear Stearns. My understanding from him was that the Fed had the authority since about 1999 to do it but had never authorized it themselves. If I understand correctly what Kudlow said I believe that there was legislative authority for their action." – Paid-up subscriber Eric May

Porter comment: Not true. There is language in the original legislation that gives the Fed great leeway in times of crisis to lend money against all kinds of collateral. But only twice in history has the Fed lent to nonbanks – and never before on this scale. And it's far from clear it has the authority to do so.

Regards,

Porter Stansberry

Baltimore, Maryland

March 18, 2008

Get Ready to Buy Some Suffering Oil Refiners

By Ian Davis

Last year, on June 4, I predicted oil refiners were heading for a fall... and boy, was I right. Oil refiners are down about 46% over the last nine months.

The title of my June 4 essay, "When Things Can't Get Any Better..." referred to the unusually high margins oil refineries were collecting.

The basic idea behind an oil refinery's business is simple: A refinery converts crude oil into usable products like diesel and gasoline.

A refinery's profits come from the "crack spread," which is the difference between the cost of oil and the price of gas or diesel. When the crack spread is large, these companies can sell their product for a large amount relative to the fixed costs of refining – or "cracking" in industry terms – the crude oil.

According to the Dallas Federal Reserve, oil prices account for 98% of the move in gasoline prices. The remaining 2% comes from outside influences...

So, what's going on with oil refiners right now?

To get a rough gauge for the economic situation for oil refiners, I created my own crack spread, using the ratio of gasoline prices to crude oil prices. I like using a ratio rather than a spread... It's the clearest way to track the performance of a refined fuel relative to the performance of crude oil. Specifically, the indicator I'm using is the price of gasoline (in ¢/gallon) divided by the cost of crude oil (in $/barrel).

At the end of May 2007, the crack spread reached a high extreme. For the refiners that weren't having outages, business was good.

For the first six months of 2007, crude oil and gasoline prices soared in lockstep, and margins remained fat. Then, gasoline finally reverted to its normal relationship with oil. Over the next three months, the price of gasoline fell by 25% while oil continued to soar... hammering the refiners' temporarily bloated profit margins.

When the fat profit margins went by the wayside, the rosy Wall Street valuations soon followed. Refiners fell from a price to book value of 3.8 (134% above their median level) to only 2.1. (This is still about 25% above the median. However, with the recent growth in the oil industry, today's slightly inflated valuations may well be cheap in context.)

The following chart shows my crack-spread indicator in relation to an index of oil refiners.

Conditions Should Start Improving for Refiners,

But Wait for the Trend to Buy

As you can see, when margins are fat, oil-refining stocks do well... but a peak is often just around the corner. Conversely, when margins are tiny, oil-refining stocks do poorly... but they also tend to be near a bottom.

Right now, margins are tiny. If you are holding refining stocks, you should continue to hang on to them but be cautious and adhere to your trailing stops.

If you are looking to buy refiners, I believe we are approaching a bottom. However, you must wait for the trend before jumping into this sector. When the sector posts a strong two- to three-week rally, that's when you know the margin-pendulum is finally swinging back in the refiners' direction.

Again, don't try to pick the bottom... but do keep an eye on your favorite refiner.

Good investing,

Ian Davis

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