"The real key to these deals was finding a dumb banker. It wasn't very hard – most of them worked at Citigroup..."
Last night, over oysters, steaks, and a very good bottle of cabernet (Shafer Hillside Select '02), I had a long conversation with a man who, for the last 10 years, put together huge commercial property developments – mostly apartments.
"We'd wave a bunch of consultants' estimates in front of his face and 'prove' occupancy would always be 92% or better," he told me. "Without lots of leverage none of these deals made any sense, so we had to have the bank. But dumb bankers never ask any questions."
"Well... How did you get out of these properties before they went bust?" I asked.
"Oh, that was easy. The bankers were dying to sell these assets to the public. They'd roll them up and IPO the assets or sell them to REITs. That the assets couldn't support the debt attached was someone else's problem..."
My main investment theme for this year is so simple I bet the average first grader could implement it. We're going to sell short every leveraged piece of real estate we can find where the rents won't cover the interest expenses. My meeting last night opened up a whole new category of real estate I hadn't thought of before – but the details have to wait until the next issue of my newsletter. Until then, if you want to know what's going to happen to all of these stocks – and there are dozens of them – just follow the General Growth Properties debacle.
Over the last three years – the halcyon days for commercial property – General Growth Properties brought in $3.323 billion in operating income, thanks to nearly full occupancy at its upscale malls. But even during the best of times, General Growth could barely cover its interest payments, which totaled $3.322 billion in the same period. And now, with occupancy and rents falling and billions in loans coming due, the company is going bankrupt.
Specifically, the firm doesn't have any cash to repay a $225 million loan from Goldman Sachs, which was due last Monday. It doesn't have any cash to pay back a $900 million loan that's already been extended to March 15. It doesn't have any money to pay back bonds totaling $395 million due on March 16. It's facing a $95 million mortgage payment due next Monday on the Oakwood Mall in New Orleans, which burned down in the aftermath of Katrina. Yet another $58 million mortgage is due on February 11, and three mortgages totaling $347 million are due March 2.
Some of my subscribers were irate with me when General Growth didn't file for bankruptcy back in December as I expected when the $900 million obligation first came due. But... that's the beauty of shorting these stocks: They were all built to fail. If you cannot afford your interest payments during the best of times, you will certainly be wiped out at some point in the next year.
It's not only property companies that are in trouble, although they do tend to be the most overleveraged. I'd be willing to bet any public company that did large leveraged acquisitions during the 2005-2007 timeframe will be at risk of going bankrupt in the next 12 to 18 months.
Take the conglomerate Spectrum Brands, for example (see chart, below). In 2005, it bought a fish-food maker for $550 million (I'm not making that up) and paid $476 million for United Industries, an insect-repellant business. (Again, I'm not making that up.) In 2004, prior to these acquisitions, the company, then known as Rayovac, had operating income of $156 million, interest expenses of $65 million, and a total debt load of $829 million. By 2006, the first full year after its acquisition spree, the company had an operating loss of $283 million, not including $177 million in interest expense and a total debt burden of $2.2 billion. Last year, the company had an operating loss of $711 million, plus it owed interest expenses of $229 million, for a combined loss of $940 million.
So you may be thinking Spectrum Brands is an anomaly. Surely there aren't many large public companies with balance sheets like this, so completely overleveraged? According to Bloomberg, operating income for 408 public companies failed to cover their interest expense in 2008 – and 255 of these companies still trade at a premium to book value. More interestingly, roughly 30 companies in the United States have operating losses and interest expenses that combine to form annual operating losses on the same scale as Spectrum Brands (larger than $500 million in annual losses). Out of these 30 firms, eight still trade around or above book value (average book value 1.08). These eight stocks have a combined market capitalization of $33 billion. I'm quite willing to bet all of these stocks are really worth nothing. Not one cent. Someone is going to make billions this year shorting these stocks. It might as well be us.
If you'd like to know exactly which companies I'm going to short this year – and there are many of them – subscribe to my letter, PSIA. Click here to learn more.
Harry Markopolos, the financial executive who repeatedly warned the SEC about Bernard Madoff's Ponzi scheme, told Congress it took him about four hours to prove beyond any doubt that Madoff was a fraud and a liar:
Madoff's math never made sense, his performance charts were clearly deceiving, and his return stream never resembled any known financial instrument or strategy... to believe in Madoff was to believe in the impossible... The biggest, most glaring tip-off that this had to be a fraud was that Madoff only reported three down months out of 87 months whereas the S&P 500 was down 28 months during that time period. No money manager is only down 3.4% of the time. That would be equivalent to a major league baseball player batting .966, and no one suspecting that this player was cheating...
I believe the same things to be true about the management teams and the bankers behind the balance sheets I've been studying lately. Nobody makes decisions this bad by accident. There's no way these companies should have taken on these debts – they had no realistic hope of ever being able to repay these obligations. And no banker in his right mind would have approved these loans. These decisions weren't merely unlucky; they were woefully, perhaps criminally, negligent. And because almost all of these firms continued to sell stock and pay dividends, they were literally paying out old investors using the money of new investors – which is nothing more than a Ponzi scheme. Nobody is talking about this next wave of the crisis. But when hundreds of companies declare bankruptcy over the next year, they will be.
Speaking of criminally negligent bankers...
Corus has $7 billion in loan commitments to condo developers and $825 million in tangible shareholder equity. It would be wiped out if the losses on these loans averaged 12%. For losses of that size, selling prices on the units being developed have to fall by more than 50%. Prices falling that far seemed hard to imagine... until the December Lennar liquidation, where prices fell 60%. In the end, Corus' future hangs in the balance of an incredibly overbuilt and fraud-ridden downtown Miami condo market. Anyone interested in buying the stock? Not me. – From the January 2008 issue of PSIA
Corus reported a $260.7 million quarterly loss last Friday and said more than one-third of its $4.1 billion of loans are nonperforming. According to the Wall Street Journal, "Amid what it called a 'precipitous decline' in property values, the Chicago lender also warned that banking regulators may soon strip Corus of its standing as a well-capitalized bank and impose higher cash requirements."
In an interview yesterday, Corus CFO Mike Dulberg said the bank is considering selling itself or finding a strategic investor. Fat chance. I'm sure Dulberg didn't mention paying a special $1 per share dividend in the middle of 2007, which allowed the controlling Glickman family to take an extra $40 million or so out of Corus just before losses soared. And I'm also sure he won't mention how the company changed its long-standing compensation practice in December 2007 to allow loan officers for the first time ever to receive bonuses on loans that hadn't been paid back yet. These are the things you ought to remember when the government says more tax dollars are needed to bail out the banks.
More layoffs... Japanese electronics company Panasonic announced its first loss in six years and cut 15,000 jobs. It will also shutter 27 plants worldwide. PNC Financial Services announced 5,800 job cuts over the next two years. Huntington Bancshares will ax 500 employees, or 4% of its workforce. And according to Dealbreaker, first-, second-, and third-year investment bankers at Morgan Stanley were extended buyout offers today... Leave and get one month's pay and a $26,000 bonus.
The situation today in the markets is particularly challenging for anyone who is retired. If you've lost part of your nest egg in the big selloff in stocks, what should you do? Should you stick it out? But what if it gets worse? And if you stay in the markets, how can you maximize the income from the assets that remain? Is there any safe way to trade options or short stocks – safe enough that even someone on a fixed income can try it? We've heard all of these questions – and dozens more just like them from our audience, which includes a large percentage of retirees.
So we're launching a unique advisory – Retirement Millionaire – written for people who are either retired or close to retirement, by Dr. David Eifrig. Eifrig isn't your typical newsletter editor. He worked on Goldman Sachs' proprietary derivatives trading desk in the 1980s, became a medical doctor in the 1990s, and decided to work for us after retiring twice. Nobody knows more about the financial needs of retirees. We hope you'll read Eifrig's introductory essays this week in DailyWealth and consider trying a subscription. I'm confident you'll find Eifrig's work useful and unique.
And possible good news? U.S. companies cut approximately 522,000 jobs in January, less than economists forecast.
Since the start of 2009, we've been telling you to buy biotech stocks. Here's yet another reason... Yesterday, S&A FDA Report pick InterMune (ITMN) announced positive results from one of the two Phase III trials of pirfenidone – a drug to treat lung disease. The stock jumped 42% on the news. George Huang used the good news to close his position... Readers who carried out George's recommended option trade made more than 100% in less than two weeks. So far this year, George has closed four trades... all winners. The smallest gain was more than 18%. Don't miss out on this biotech mega trend. For more information on the S&A FDA Report, click here...
New highs: none.
In the mailbag... Judging by the compliments, some of our subscribers have gotten into the booze again. Send your thoughts here: feedback@stansberryresearch.com.
"I have had very similar thoughts to yours (you and your firm) for the past few years in regards to the markets. I find you and the people who work with you in these publications have very sound advice, although typically too early on your calls. Better early, then not at all I suppose. I would like to thank you for providing quality investment advice in a world where very little exists. One of my clients recommended your service to me and it took me some convincing to realize that the used car salesman form of marketing you are using actually had some valid reports behind it (your "marketing pieces" vary greatly from your publications). After reading a few of the articles, I found your publication to be of great service to him and others who I will share your advice with. I am signing up for your service for my firm and all the clients, which I advise. I wish you all the best and hope you continue to stand apart from the crowd." – Paid-up subscriber Kirk
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Regards,
Porter Stansberry
Baltimore, Maryland
February 4, 2009