"Maybe what we should have done was not bought it," said Steve Feinberg, co-founder of hedge fund Cerberus Capital Management, in regard to his firm's ill-fated 2007, $7 billion purchase of Chrysler. Longtime readers will recall my sarcastic quarterly letters from the "chairman" of General Motors from exactly the same period. Using the satiric voice of the "chairman," I explained a serious fact: GM couldn't afford the $5 billion in interest it owed on its debts each year. And as its credit rating fell, its interest expenses would rise, resulting, inevitably, in a bankruptcy filing.
Although you had to be able to read financial statements to determine these facts, it didn't take much more than common sense to realize a company that hadn't earned enough money to pay the interest on its debts since 1992 and had added to its debt pile in 19 of the last 20 years probably wasn't going to make it. Here's the incredible part: Chrysler's debt load was even larger. It would have to earn $10 billion a year, just to pay the interest on its obligations.
With the Cerberus-Chrysler story in the back of your mind... allow me to share two secrets I know to be true about hedge funds. First, they are all destined to fail. And second, the entire industry consumes capital. Thus, while you might make money on a given fund, in total, hedge-fund investors are destined to lose money.
Why? Hedge funds are doomed by the Peter Principle. The Peter Principle, you'll recall, is that in the corporate world people tend to be promoted to the point of incompetence. Someone who is a really good salesman isn't necessarily a good manager. Someone who is a good manager isn't necessarily a good corporate executive. And someone who is a good corporate executive isn't necessarily a good CEO. But nobody knows where they'll top out in ability before it's too late. The same thing is true with hedge funds – with catastrophic financial consequences.
In the case of Cerberus, Steve Feinberg was a great distressed (junk) bond investor. Michael Milken trained him. He has an unbelievably high I.Q. and beat almost anyone in chess – blindfolded. This gave him a valuable edge in the debt market and attracted a large and powerful group of investors. They promoted Feinberg, in terms of capital and influence, into the top rung of the hedge-fund world – where he failed miserably. He reached his Peter level. And his investors lost $6 billion last year. While I don't know it for a fact, my guess is that's more money than Cerberus earned, in total, to date.
Here's how it happens: These fund managers pile their gains up and reinvest their capital in their next big trade. But... sooner or later they reach a level of capital under management that requires them to move into new areas. And eventually, they blow up. I know of only one hedge-fund manager who cashed out of his entire fund near the top in 2007. Only one.
Last October, we were among the first people to point out the real meaning of the AIG bailout: It was actually a bailout of Goldman Sachs:
We'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG.
Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion... – Porter Stansberry's Investment Advisory, October 2008
Who engineered the bailout of AIG? Hank Paulson, of course, who was Goldman's CEO until 2006. Last weekend, the New York Times published a great exposé of the role Paulson played in the bailout. And guess what? According to Paulson's personal calendars, during the week of the AIG bailout, Paulson and Lloyd Blankfein – the current Goldman CEO – talked two dozen times – far more frequently than with other Wall Street execs.
Actions Paulson took that week required a special ethics waiver from the Treasury and the Office of Legal Council. I highly recommend you read the article, which shows just how deep Paulson was involved in the Goldman Sachs and AIG bailouts: Paulson's Calls to Goldman Tested Ethics.
We wrote it, did you short it?
I'm fairly confident all of these companies will either go bankrupt or suffer massive dilution in order to restructure their balance sheets. I don't think debt financing will be available in the next decade for firms with this much leverage. The debt-centric business model is quite simply dead. – Porter Stansberry's Investment Advisory, March 2009
Just below this quote in my March 2009 issue of PSIA, I listed 11 companies I thought would go bankrupt based on their massive liabilities and the eroding value of their assets...
Maguire Properties – the giant, Los Angeles-based mall owner – topped the list. The stock was already down some 70% to $2 a share from its peak... It has since dropped to less than 90 cents. And according to the Wall Street Journal, things are still worsening.
Maguire made the biggest mistake a REIT could make... The company loaded up on debt to make acquisitions at the market peak. And Maguire's purchases happened to be in California, one of the hardest hit real estate markets in the U.S. Now, the REIT plans on handing seven buildings, with around $1.06 billion in debt, over to creditors. The company is facing "imminent default" on the loans. The buildings are all worth less than the value of the mortgages and aren't generating enough cash to service the associated debt and cover leasing expenses. Maguire acknowledged it may restructure the debt, but it's more likely to just hand the buildings over, which make up about 20% of Maguire's portfolio.
Even after dumping the underperforming properties, Maguire is still in trouble. The company has $3.5 billion in debt, which many analysts say is more than the value of its properties. "Almost every building in [Maguire's] portfolio is under water," says Michael Knott, an analyst with real estate research firm Green Street Advisors. "I don't envy some of the choices that they are having to make."
Warren Buffett's Berkshire Hathaway posted $3.3 billion of second-quarter earnings – up from $2.9 billion a year ago. The firm gained $1.5 billion from investments and derivatives – including huge gains from Goldman Sachs and the Chinese car company, BYD.
And in a telling sign where Buffett sees stocks headed in the future, he added billions of dollars to his government and corporate bond positions. At the end of the quarter, Buffett held around $11.1 billion in foreign government bonds, compared to $9.6 billion three months earlier. He spent $2.6 billion on fixed-income in the three months ended June 30, compared to $350 million on stocks. He also holds large preffered-stock positions in Goldman Sachs, Swiss Re, and General Electric. In total, his fixed-income investments are paying $1.8 billion in interest annually.
If you're interested in the best corporate bonds to buy – which can provide you with double-digit yields for years to come – check out our bond letter, True Income. Mike Williams, a veteran bond analyst and our only writer to earn his Chartered Financial Analyst accreditation, writes it. Of the seven bonds he's recommended this year, six show double-digit returns already... including one position that's up more than 160%. To find out more about True Income, click here.
New high: CuraGen (CRGN).
In the mailbag... Some advice from an Argentine and a question about ethics. Send us your questions, we'll take a stab at answering: feedback@stansberryresearch.com.
"I couldn't agree any more with your comments, about the 'inflated-unreal' reallity the u.s. government is fluffing. and for that matter almost all 'modern' americans, were for a long time up to now, living a fake rich life: huge house, 5% of it is yours, the rest belongs to money that doesnt exist, but its on BofAs balance sheet, with bernankes last name on it... super-car also on credit, and even most of the fridge's food is not yours but capital one's! but then again who cares! im rich! dont i look like one? where I live , in Argentina, the government did the same crap (with few obvious differences) since 1930, then an economic super power, till 2001, a totally bankrupt screwed up country. and we have learned very powerfull lessons, from wich I can answer your question porter how you'll look in 20 years:
"government WONT change! the oposite, they will control more and more, they will do more laws to 'protect' poor voters (actually destroying them in the process) and screw companies, capital inflow etc. etc. even as THEY SEE they are eating up the floor they're standing on... it wont matter.
"I'll take as much as I can and then when it all explodes... who cares! juan domingo obama is just the begining of you peronist era! *the ones who will see their accounts, their currency, their ability to do bussiness, their hope etc. shrink will be the private sector. and you know what? *then you guys will learn NOT TO PROFESSIONALLY 'BUY' TWO HOUSES YOU COULD NEVER (AND ACTUALLY NEVER DID) BUY! here, we work 35 years saving every single month a little, and then put together those savings and buy an appartment with cash. thats how 80% of realestate deals are done here, bill ontop of bill. i could go on and one, but I'll leave that for another time. regards." – Paid-up subscriber cach
Porter comment: The government bails out the auto sector, gives most of the new equity to the unions, screws the legitimate bondholders, then gives people $4,500 to buy cars from said automakers. What are you talking about "how we'll look in 20 years"? We're there right now. Welcome to Amerika, Komrade.
"I agree completely with your argument that one should always honor one's debts. It's the ethical thing to do, regardless of the stupidity of the bankers that lent to unqualified mortgage applicants. Since we're on the subject of ethics, I would like your opinion of a proposal advocated by an associate of Agora publishing, Doug Casey.
"Mr. Casey posits that in the near future, interest rates will skyrocket, as the dollar shrinks from the tremendous debt burden incurred by our government. He is advocating that his readers borrow as much as possible against their homes now while interest rates are near record lows. He believes rates will soon spike, and the debt will be paid back with increasingly worthless dollars, as hyperinflation sets in. Is this ethical? I would be borrowing funds today that have some value and paying back the debt with a currency that will be worthless in the future. Granted, I would be honoring my contract, but I would hardly be trading value for value.
"The people who are severely upside down on the mortgages are defaulting not because it is the ethical thing to do, but in their minds it is the 'smart' thing to do. Just as paying back a debt with a worthless currency is a 'smart' thing to do. For the record, I have lived in the same modest 1,850 sq.ft. home for the last 18 years. I have never done a cash-out refi., and I have less than four years left on my mortgage, when I will be debt free." – Paid-up subscriber Daniel Anthony
Porter comment: Yes, I believe it's ethical to take a loan from a bank at a low rate of interest. It's stupid for the bank to offer you such a loan, but that's the bank's problem. You're not forcing it to do it. Nor are you misrepresenting your assets or income in any fraudulent way.
On the other hand, I don't think such a speculation is wise. I certainly agree with Doug that we're on the verge of a huge inflation, larger than anything the world has ever seen before. Never before in human history has the world's entire economy been linked by the paper currency of a bankrupt nation. When the world decides to flee from the dollar, the consequences will be unprecedented.
But this has been true for a long time. Answering the "when" in this scenario is impossible. Borrowing a lot of money at 4% is probably a good idea, assuming you can find a place to put it to work at a nice profit. But taking the money just because you think you won't really have to pay it back (because of inflation) doesn't make any sense to me. I'd rather own my gold outright and sleep well at night. If Casey and I are right about the looming hyperinflation, owning just a bit of gold will be enough to make you a rich man, comparatively.
"Why is Porter sick all the time? It seems like he is sick about every week and this time it is lasting a long, long time. I think that maybe Doc Eifrig should think about taking Porter under his wing fore a year or two. Hell, I'm 75 years old and I haven't had a cold in almost nine years now. Porter is definitely doing something wrong." – Paid-up subscriber Ron Putman
Porter comment: Until about a year ago, I never got colds or the flu. But my son is two now. And he plays nearly every day with lots of other kids his age. They're like a germ factory. Now I get sick about every three months.
"Congratulations on your 10 year anniversary! That is quite and accomplishment being in the business that you are in, or any business for that matter. You deserve a pat on the back. I've really enjoyed my subscription as an alliance member, keep up the great work. I hope I can wish you a congratulations on your 20th anniversary, I'll provide the wine!!!" – Paid-up subscriber Bob Greene
Porter comment: Thanks... and that's not a safe offer!
Regards,
Porter Stansberry
New York, New York
August 10, 2009