The S&A Digest: The millipede upstairs

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The millipede upstairs... Lehman takes a hit... big bank 'expectations' vs. losses... FGIC splits in two (maybe)... Adios, Jefe... Wolf Creek golf resort...

 A mortgage banker friend warned me about this last week. He said we'd keep hearing about bigger writedowns from those who have already written down.

It's those darn other shoes. Not shoe, singular. Shoes, plural.

They just keep dropping (and dropping, and dropping... ). It's as though we all live in the apartment below a man-sized spider slowly removing the shoes from each of his eight legs before turning in for the evening...

After the second shoe drops, we nestle back to visions of sugarplums, rising stocks, and low-interest refinancings. Then, "THUD!," the third shoe hits his floor, our ceiling.

"What was that?" we think to ourselves. Is he married? "THUD!" No. 4 drops. Okay, now he and his bride are barefoot and we can all go to sleep... until...

 "WHAM!" Lehman Brothers drops shoe No. 5: commercial real estate loans. Of $90 billion of debt on Lehman's books, $39 billion is from commercial real estate loans. Lehman was quick to cut its residential lending in the face of the subprime crisis, but it did what so many in the finance industry do: It made up for lost volume elsewhere. Lehman aggressively lent to commercial buyers. The bank expects to write down $1.3 billion for the quarter, up from a recent $800 million estimate.

"Expectations" from big financial companies are obviously pure B.S. Merrill Lynch wrote down almost $8 billion after expecting losses only half that size. Citigroup wrote down more than $18 billion last month – again, double its expectations. If your mechanic did this to you, you'd sue him. Will it surprise us in the least when Lehman's $1.3 billion turns into $2.6 billion?

Hmmm... maybe the man upstairs from us isn't a spider. Maybe he's a centipede... or a millipede. We won't know until the last shoe drops. And we won't know it's the last shoe until we bust down his door and count his bare feet.

It's become obvious that nobody knows how much any bank has really lost until after it's lost it. However, banks also know that investors can be hoodwinked over and over by putting out a number and adding to it later. They'd rather try to preserve some of their stock's value than tell the truth – that a $1 billion expected loss could be $5 billion or $20 billion... They don't know and won't know for... who knows how long? Not me.

All kinds of banks, from the smallest to the largest, are still getting blindsided. Anyone who says they know what anyone's losses will be is either a bona fide clairvoyant or a misguided fool.

 Credit Suisse is dropping another shoe today as well... Switzerland's No. 2 bank says it's suspending a "handful" of traders for overvaluing assets by – better sit down – approximately $2.85 billion. Broker Peter Thorne says Credit Suisse "may be simply bad at knowing what problems they do have."

Credit Suisse's shoe dropped two days after the Gulf Coast nation of Qatar said it was accumulating a position in the bank. So far, it's just an equity position, but the idea of Qatar bailing out Switzerland makes sense when oil is near $100 a barrel and paper assets of all types are blowing up left and right.

 Here is a hilarious and simple explanation of the subprime crisis. (Viewer discretion is advised.)

 New York insurance superintendent Eric Dinallo says bond insurer FGIC will split in two. One division will hold the safe municipal bonds – the bonds the government wants to save. The other will hold all the toxic-waste risks, like exposure to subprime mortgages and CDOs.

The split structure aims to protect the muni bonds with AAA ratings, meaning municipal and state projects can be funded at reasonable prices. (If they're backed by the power to tax, why do they need ratings at all?) If MBIA and Ambac split as well, $580 billion of asset-backed securities will probably be cut, leading to an additional $70 billion in writedowns for major banks.

The details of this proposed transaction are unavailable. FGIC hasn't filed any sort of a plan. Dinallo suggested during a CNBC interview that there could be other possible outcomes. "We're not done on FGIC. Someone could inject capital." It's all still up in the air, swirling around with the detritus in Manhattan's financial district, which takes flight in a good, stiff breeze.

 Signs of a top in lead prices? Thieves in Britain are stealing the lead roofs off old English churches. Across the U.K., churches have filed a record number of insurance claims for lead-related losses.

 In a letter dated yesterday, Cuban dictator Fidel Castro officially retired after 49 years of... well... dictating. Castro wrote, "It would be a betrayal to my conscience to accept a responsibility requiring more mobility and dedication than I am physically able to offer." Castro says he'll "neither aspire to nor accept, I repeat, I will neither aspire to nor accept the positions of President of the State Council and Commander in Chief."

For investors, a bigger problem than Castro is the United States' ongoing embargo against Cuba. Cuba could be as free as a bird, but if the U.S. government makes it a crime to do business with Cuba, you're not going to invest a penny there unless you engage in extralegal activities. The U.S. government, economically destructive as ever, is essentially guaranteeing that other countries will invest in Cuba before you and I get the chance to do so.

I can think of at least two stocks with investment angles in Cuba... both of them highly dangerous speculations I wouldn't touch with a 10-foot pole. One was a Canadian penny stock called Leisure Canada. The other was a pink-sheet stock called Cuban Electric Company. The latter was 88% owned by Boise Cascade and owed Boise some huge amount like $100 million or $200 million. I haven't even thought about either one for years. I have to wonder aloud... Where are they now? There's also a fund called Herzfeld Caribbean Fund, which went up 20% today on the news about Castro.

Ever been to Cuba? Let's hear about it at feedback@stansberryresearch.com.

 New highs: none.

 Write to us about shoes, your upstairs neighbors, or any other financially oriented topics at feedback@stansberryresearch.com.

 "The S&A Digest references the recommendation for RGR. However, I can only find it referenced in the Penny Letter and those articles are no longer available even though I am an Alliance member. How do I get your research on RGR?" – Paid-up subscriber Stanley Levine

Ferris comment: If you're an Alliance member, you should have received the S&A Penny Letter, including a copy of my December 2007 report on Sturm, Ruger (RGR). The reports are temporarily offline (we're working on it), but I'm still doing monthly updates on all open positions.

 "My brother and I made the worthwhile drive from Las Vegas in July of '03. Played the next to the back tees and found you had to stand behind your buddy to follow the ball because you were so far above the fairway (12 stories at some tees). Shot 73 and am looking at our photo as I write. Your ball was on something green or it was on restricted enviornmental areas. There were places where I saw literally hundreds maybe over a thousand balls just sitting in these areas. I am the green committee chair at my course in North Conway, NH and I have to tell you this place is spectacular. To maintain this place is an act of love. If you are anywhere near and love golf you will not regret the drive to tee it up at Wolf Creek. The family that built this place and run it are top notch." – Paid-up subscriber Peter Hill

 "In the February 15th or 16th issue of IBD they wrote that 23.9% of individuals actually own non-tax-deferred mutual funds. About 39% have IRAS or Roth IRAS. I am curious then about how many individuals in the U.S. actually buy individual stocks? Its not a life or death question but recently I'm finding people at work who can't even cash a check and rely on Check n' Go payday loans between paydays so I'm guessing all these newsletters, IBD, Wall Street Journal etc. go to a pretty small number of people." – Paid-up subscriber Robert

Ferris comment: The newspapers you mention certainly have a much larger audience than any newsletter, though I'm not familiar with the up-to-the-minute statistics. I remember hearing somewhere that 50% of U.S. households have brokerage accounts. But that was earlier in the decade, when everyone thought stocks were easy money.

By the way, those folks where you work are almost certainly among those who'll pay 36%-60% APRs for tax refund loans from Extreme Value pick H&R Block (HRB) this tax season. Richard Breeden, Block's new chairman, says the holes are plugged and the company is ready to move ahead. That's great news if it's really true, because the tax preparation business is a very good one.

I tend to believe Breeden more than the manager he replaced, because Option One (its subprime mortgage originator) has already been playing out for a couple years now. The tax prep business can produce an operating profit of $1 billion in a single year for Block, and its equity is selling for about six times that amount.

Good investing,

Dan Ferris

Medford, Oregon

February 19, 2008

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