Druckenmiller hangs it up

Stanley Druckenmiller is hanging it up. Facing the first down year in a 30-year career as a hedge-fund manager (his main fund is down about 5% this year), Druckenmiller has decided to return his clients' capital and retire. We think you'll see more of this – that is, more hedge funds going out of business – as the global credit bubble deflates.

Druckenmiller's career happens to correlate perfectly with the largest inflation in history. As credit multiplied between 1980 and 2010, folks like Druckenmiller were paid unbelievable sums for managing the resulting capital flows. But... the credit spigot has been tightening up, at least for private capital. Now, the only bubble left is the one being blown up by Washington in the form of Treasury obligations.

Speaking of the credit bubble... here's an important trend worth watching: the battle over "reps and warranties." One of the primary reasons the housing bubble got so out of control and why so many bad loans were made during the 2003-2007 period is because securitization allowed mortgage originators to sell bad loans to other financial institutions. Originators didn't care about credit quality. They didn't hold the loans; they sold them. To protect the buyers of mortgage securities from fraud, originators had to agree to a series of legal representations ("reps") and provide a warranty against default for some period of time. So... what's happening now with all of these bad loans, nearly all of which violated the representations made about their underwriting?

Most of these loans ended up on the books at Freddie and Fannie, which bought something like $400 billion in nonprime mortgages during 2005 and 2006. (As usual, the government agencies found a way to buy the worst mortgages at the worst time...) As these two firms sort through the paper trails on all of their bad loans, they first contact the mortgage insurance firms – typically either MBIA or Ambac – to make a claim. The insurance companies then prove that the mortgage was fraudulently underwritten and deny coverage – something called rescission. At that point, Fannie and Freddie send a claim back to the originators, firms like Wachovia and Countrywide, which the surviving banks, Wells Fargo and Bank of America, now own.

As you can imagine, the whole process is like a game of hot potato. No one wants the liability for the potential losses on a defaulted mortgage. The underwriter denies any claim of fraud and argues the mortgage was properly insured. The insurance companies claim fraud. And Fannie and Freddie say it's not their fault, it's the underwriter's responsibility. Things were pretty much at a legal standstill until Fannie and Freddie's newest regulator got involved and sent subpoenas to 64 mortgage underwriters. That's when the proverbial "stuff" hit the fan. Analysis by Chris Gamaitoni of Compass Point Research & Trading predicts massive additional undisclosed losses at Bank of America, Wells Fargo, JPMorgan and Citigroup – led by $7 billion at Wells Fargo. Total losses (both disclosed and undisclosed) due to reps and warranties could be as high as $17 billion at Bank of America.

There's a flip side to these losses, however – the matching decline of liabilities at the mortgage insurance companies. Check out MBIA, for example. It's a $2 billion market cap mortgage and municipal bond insurance company. It holds almost $35 billion in assets, including about $3 billion in cash. On the other side of its balance sheet, however, are more than $20 billion insured losses, mostly mortgage insurance claims. Every dollar of insured losses that MBIA is able to rescind because of reps and warranties is probably worth $5 or $6 in market cap. If you were able to rescind half of the $20 billion in mortgage losses, you'd probably see the stock trading closer to $60 than $6.

There's another factor to consider... The need to paper over the enormous legacy losses of the housing bubble is what explains the Fed's policy of zero percent interest rates. Right now, it costs the banks almost nothing for capital, which means huge profits on loans. The profits are necessary to make sure they can afford the legacy housing bubble losses. What's not a part of this calculation is the true cost of zero-percent interest rates. In that environment, people have little reason to save or invest. Can our economy survive zero percent interest rates and an avalanche of new paper dollars? We don't know.

In the mailbag... two good questions. Don't forget: We read every single note you send us. And while we can't reply to everyone, we always consider your questions, suggestions, and complaints carefully. Don't allow your subscription to expire without sending us something, anything. We want to know that you're reading our work – whether you like it or not. Send your note here: feedback@stansberryresearch.com.

"I've heard you and several of your analysts talk about the Federal Reserve's recent action of monetizing debt. Why is this a bad thing? I'm not saying I think it's a good thing, and I get what they're doing (ie: taking proceeds from mortgage securities and rolling it into US Treasury debt). I'm just not sure I understand what the economical ramifications are/could be. Perhaps a layman's explanation?" – Paid-up subscriber Justin Seli

Porter comment: The ability of the U.S. Federal Reserve to buy an unlimited amount of Treasury bonds (or any other asset in time of a financial emergency) isn't a bad thing at all – on the surface. This ability, and the unique role that the U.S. dollar plays as the world's reserve currency, means no major U.S. financial institution will ever default on its obligations. It also means the U.S. government – unlike Greece or Argentina – will never face a credit crunch. This power is why the U.S. government is the only creditor in the entire world that has the power to legally print the money that's required for the repayment of its debts, and can do so in a currency that's universally exchangeable. Greece can't print euros. And Argentina can't print dollars. But our government can print all the money it needs to repay all of its obligations. It can also cover the obligations of all its financial institutions.

The problem is, access to this kind of unlimited financial power produces (eventually) wholly unrealistic expectations about what is financialy prudent. Imagine how you might live if you had control over a credit card whose bill never would come due?

I think it's unwise to give any government that kind of unlimited financial power – governments have historically been unable to resist the temptation to spend too much. Eventually, that leads to a collapse of the financial order as people abandon the reserve currency en masse. The hard part is, it's hard to know when the imbalances caused by the U.S. government's excessive indebtedness will trigger such a run. We do know a major landmark on the road to collapse was the step taken last week when the Fed committed to an ongoing policy of buying U.S. Treasury obligations.

"After reading Bob Jones from NAHB's comments the following items come to mind. As an appraiser of over 20 years duration, I find it interesting how whenever a builder loses a sale it's because of an 'inaccurate' appraisal, never that the house was overpriced for its market. When they state the appraisal was inaccurate, this usually means the appraiser did not come in at the value the builder wanted. Most lenders have a process for interested parties to submit a request for corrections to appraisals, if something is incorrect. But most times the builders are unable to provide anything substantial beyond 'I have an offer for a higher number.' In contrast, the appraiser, who is state licensed and monitored, has provided at least 3 closed sales supporting his value estimate.

"Reminds me of my old friend from Mississippi, Johnny, who when caught by his wife in flagrant delecto in his car, asked her, 'Who you gonna believe, me or your lying eyes.' As for the rest of Bob Jones from NAHB statement, if the number of distressed properties in the neighborhood is causing sales of new homes to fall thru, maybe the builder should find a new neighborhood to build in where the sitting inventory is not so high. Why build where there are a bunch of vacant houses. And as for banks tightening their lending standards, it's about time. Liar loans and 110% LTV's got us into this mess." – Paid up subscriber Robert Campbell

Porter comment: You touch on a bigger problem... How can we solve a problem of too many houses and too much debt by building more houses and borrowing more money?

Regards,

Porter Stansberry
Baltimore, Maryland
August 18, 2010