Is a company a "financial company" if more than half of its revenue comes from finance-related activities? What if 83% of that company's assets ($646 billion) are financial assets like business loans, mortgages, and commercial real estate? What if it offers mutual funds and credit cards? The obvious answer is YES. But the U.S. government has a different opinion...
Last week, the Senate approved a financial reform bill that will increase regulation of the nation's largest finance companies. The legislation bans large financial firms from owning hedge funds and increases regulation on derivative trading, among other things. But the legislation only applies to companies "predominantly engaged" in financial services, defined as those where at least 85% of annual revenue or consolidated assets come from financial activities. GE (the company described in the introductory questions) just misses the mark... Only 83% of its assets are finance-related. "This is the right application of regulation," said GE Capital spokesperson Russell Wilkerson. "We support it. We shared these views with members and staff."
But we all know the company is essentially a giant bank...
GE started its finance arm to arrange financing for its customers buying large, industrial products. But GE Finance felt left out as the big banks made billions from consumer lending. Under the direction of former CEO Jack Welch, GE expanded its finance business into mortgages, credit cards, and nearly every other "easy money" loan it could make. The company's balance sheet ballooned and the market cap soared – GE's spectacular debt-fueled growth earned Welch a "manager of the century" award from Fortune in 1999. Welch transformed the world's leading industrial manufacturing company into a highly leveraged bank. GE was now susceptible to the credit risk that would eventually crash nearly every financial institution on Wall Street. And just like every other Wall Street institution, GE received a government bailout. The government gave GE $140 billion (behind only AIG, Citigroup, and Bank of America). Shouldn't it be governed by the same regulations placed on these other financial institutions? We think so...
Then why is the government excluding GE from its increased regulations (which Wall Street expects to eat 15% to 20% of annual profits)? Because the government knows GE couldn't survive the regulation. The company needs every penny to finance its massive debt load. And if GE went bankrupt, especially in the face of current market action, our economy would explode. In Porter's November 2009 issue, he explained exactly how bad GE's financial position really is...
In GE, we see all of the signs of an unavoidable bankruptcy. It's built a long history of net debt accumulation. It carries huge amounts of short-term debt. (Specifically, before the end of 2012, GE must repay or refinance $240 billion.) It has a tremendous pile of average to below-average assets, many purchased at inflated prices. GE's long-term asset base grew $200 billion (or 30%) between 2003 and 2008. GE is now engaged in a desperate effort to sell assets: 145 different divestitures, totaling at least $100 billion.
Finally, there's the "kiss of death." We know GE's funding costs on its debts are about to soar. It has lost its triple-A rating and will most likely continue to be downgraded. In fact, last year, the U.S. government had to guarantee $500 billion in GE's debt. Without the guarantee, GE would have gone bankrupt already.
With the guarantee, GE only spent $4.3 billion on interest in the last quarter. So on an annualized basis, GE is now spending roughly $17 billion each year to service its $683 billion in debt. That's an annualized interest rate of 2.4%. This is not sustainable. Sooner or later, GE is going to have to pay a market interest rate. The government guarantee expires in 2012. – Porter Stansberry, November 2009, Porter Stansberry's Investment Advisory
While the GE short recommendation remains flat, the company is breaking down...
If the financial oversight legislation isn't going to actually oversee financial companies, why does it exist? To attract campaign contributions, of course... According to an analysis by Citizens for Responsibility and Ethics in Washington (a nonpartisan group), 14 congressional "freshmen" serving on the House Financial Services Committee raised 56% more in campaign contributions than other freshmen. And most freshmen on the panel are currently in re-election battles.
"It's definitely not accidental," said Melanie Sloan, the director of the ethics group. "It appears that Congressional leaders are deliberately placing vulnerable freshmen on the Financial Services Committee to increase their ability to raise money." One representative on the Financial Services Committee, John Adler (D-NJ), is an unknown freshman in Congress. But he raised more than $2 million for his re-election, the most of any freshman. Coincidentally, investment firms and insurers were his largest contributors.
In the May 14 Digest, we explained why more government regulation was not the answer to the credit-rating agencies' flawed business model. Jonathan Weil of Bloomberg poses that regulation is a secondary issue. First, he says, we must address the firms' biggest problem... The fact that they're terrible at rating debt:
Consider the wide divergence in ratings for a mortgage bond issued five years ago called Park Place Securities Inc. Series 2005-WHQ2. The eighth-highest tranche in that offering, dubbed the M-2 class, is rated AA+ by Standard & Poor’s, one rung below its highest level. Moody’s Investors Service rates the same bond B1, or four notches below investment grade. Fitch Ratings calls it CCC, signaling a high risk of default.
A division of Hartford Financial held this bond on the books at 25 cents on the dollar as of yearend 2009. The bond is junk. But depending on which credit rating firm you listened to, the bond was either top notch, junk, or somewhere in the middle. And S&P still maintains its double-A-plus rating of the bond. How is regulation going to solve this kind of stupidity?
New highs: none.
If you buy a stock on our recommendation, make sure you sell on our recommendation, too... feedback@stansberryresearch.com.
"I can't believe the discourse on inflation I just got through reading! Increases in price as it is related to inflation is nothing more than a symptom of the Fed's 1919 definition of inflation. To paraphrase the Fed, inflation is too many dollars chasing after too few goods, this will eventually drive up price because price=supply+demand. If you hold demand constant and decrease production/supply, prices will rise – increasing money supply without increasing production/productivity=inflation. Prices rising is a symptom not the cause and thus not the definition. It's no wonder why markets rise when they should fall, and fall when they should rise!" – Paid-up subscriber Dennis Filosa
"I have purchased NLY three times. Lost capital value all three times equal or in excess of dividends. The most recent was 615 shares at average cost of $18.12 PPS starting 8/2009. On May 5, 2010 at $15.576 pps my principal loss was 14% – essentially on schedule to wipe out dividends or more.
"Why do you all love it so much? Each purchase I made was a reco by Stansberry editors, and each time I either lost money or broke even with dividends applying a stop loss in each case." – Paid-up subscriber Richard Kuidis
Goldsmith comment: Maybe you're setting the wrong stop loss. When you're dealing with a huge dividend payer, like Annaly, it makes sense to subtract the dividend you earned from your stop price. For example, let's say you buy a $12 stock that pays a $1 annual dividend. You set your stop at $9. After one full year of dividends, you would move your stop to $8 (accounting for the $1 in dividends you earned).
Regards,
Sean Goldsmith
Baltimore, Maryland
May 24, 2010