How to "game" the paper currency system...
How to "game" the paper currency system... Why asset prices aren't allowed to fall... Will the feds protect the U.S. dollar?... Big upside is possible in MBIA shares... Why you should buy the S&A Alliance now...
Today's Digest is a bit disjointed. Normally on Fridays (when I write the Digest personally), I try my best to talk about some part of finance I'm fairly certain most of our readers don't understand. But today, I want to continue our discussions from last week about the structure of the world's monetary system. (You can read the June 20-24 issues here.)
The system has been under a lot of pressure since 2008. Cracks are beginning to form. And though the authorities are trying their best to "plaster over" these problems... I remain convinced their efforts will fail. These issues are the central financial questions of our time…
I'm not going to talk about complex economic theory today – at least not in great detail. All you really need to understand is this: By creating an incredible amount of credit around the world, the paper monetary system has financed decades of consumption that wasn't backed by production. Most western democratic nations have consumed far more than they've produced over the last 40 years. Their governments are trying to sustain this system because of its obvious political advantages: Promising voters something for nothing is how to get elected in a modern democracy.
But... the system itself is beginning to fail because the amount of debt created over the decades can no longer be financed with accounting gimmicks or phony insurance schemes. Greece, for example, isn't facing a liquidity crisis. The nation is insolvent. That's why last year's bailout didn't work and why I don't believe the new 30-year debt extension in the news this week will work, either.
So what will happen now?
Let me start by telling you about Andy Beal.
Andy Beal is a real person. He's made more than $1 billion over the last decade by simply exploiting the paper-money banking system. As you'll see... the fact that Andy's a billionaire suggests something is terribly wrong with our money. The ironic part? Andy would be the first one to tell you all about what's wrong with the system.
Andy Beal is a banker… on paper, anyway. But he's not really a banker at all, at least not in the way most people think of bankers. Beal doesn't offer people checking accounts or provide much in the way of retail branches. He garners most of his deposits through brokers by offering much higher interest rates than you could normally find in an FDIC-protected account. Beal Bank pays 1% annually for annual certificates of deposit, instead of 0.5% like Bank of America offers.
Beal can easily afford to pay for his deposits because he boasts a 27% annual return on equity, which is unheard of among commercial banks. This is where the story gets interesting. You see, Beal's returns would be impossible in a stable banking system.
How does he make his money? Is it with extreme leverage? Nope. His Nevada bank, for example, has 35% of its assets in cash right now. Beal uses the government (through its Federal Home Loan Banks) to get money for next to nothing. Then, he invests capital into distressed assets…
For example, after the 9/11 terrorist attacks, Beal bought up distressed airplane loans, which were fully collateralized by working aircraft. He bought some of this paper for as little as $0.38 on the dollar – and then collected at par ($1). He has made money by lending to companies in bankruptcy, so called "debtor-in-possession" loans that are always fully collateralized and essentially subordinate to other bondholders. His best year ever was 2008-2009, when he bought $5 billion of distressed mortgage securities. As he told Bloomberg: "I wish we'd done twice as much. The sky was falling."
But as you know, the sky didn't fall. Instead, the Fed and the European Central Bank pumped the world full of bailout money and manipulated interest rates so the big banks could make plenty of money. That "reflated" the system. It prevented asset prices from falling, as they would have if we lived in a world of sound money, where consumption would always balance out with production over time. That Beal always makes money and generates such huge returns shows how flawed the system has become…
Beal takes advantage of the system in two ways. First, he gets all the super-cheap funding he can get, at the lowest possible price, by using brokers to get FDIC-insured deposits and then borrowing additional capital, for next to nothing, from the Federal Home Loan Bank in Dallas. That's the easy part: Beal knows when there's a crisis, the Feds will always make sure he has access to plenty of capital.
The next part is tougher and shows you how well Beal understands the game… He only puts this capital to work when he can buy things that are distressed – when the price he's paying is far less than the underlying collateral is worth. That's exactly the same technique we've stressed (over and over and over) when it comes to buying corporate bonds.
Beal knows he can't lose money on these operations for one simple reason: The monetary authorities cannot afford for asset prices to fall. If they do fall, the entire system will collapse. After all, they're on the hook for all of Beal's deposits. Beal knows there's not ever going to be a real debt liquidation. The central banks will never allow consumption to decline to meet production. Instead, government deficit spending, manipulated demand (cash for clunkers), or bailouts (TARP, the new Greek 30-year debt, etc.) will push asset prices higher and higher. Money supply will grow. Credit will be expanded.
In this global paper standard, you can always count on the government to keep defaults from spreading too far. To make a fortune, all you need is guaranteed access to capital (the Federal Home Loan Bank line of credit and brokered deposits) and the discipline to build enough cash equity during the boom phases to load up on distressed assets during the busts.
Today, Beal's banks have shareholder equity of $3.2 billion. And he's not buying anything.
"Today's markets are being supported by a flood of money," he told Bloomberg. "There are so many lenders in a race to the bottom when things are good. We don't participate in that."
Beal knows he's gaming the system. And ironically, he despises the government. "I hate big government," he says. "I don't like the government-issued paper currency rules or the laws that require its use. But those are the rules, and I live by them."
When people talk about deflation versus inflation, they're debating whether the global credit bubble will eventually lead to a massive deflation (where asset prices would collapse, allowing consumption to decline until it's equal to production) or a hyperinflation (where vast instability in prices leads to a decline in consumption until it equals production).
I've always known the end game will be inflation. The whole premise of the question makes me chuckle. Show me an example in history where a paper currency gained in purchasing power as the issuing country went broke. It doesn't happen. What will happen, sooner or later, is a massive run on the U.S. dollar. I can't tell you exactly when it will happen, but I can tell you the signs of approaching trouble…
We're looking at many of them right now: Trading partners have begun avoiding the dollar for bilateral trade (Russia and China). The prices of gold and silver are soaring as central banks try to escape the U.S. dollar. Debt loads that can't be financed (in Europe, and U.S. banking system, U.S. homeowners) are creating massive economic problems. Prices for strategic commodities (copper and oil), foodstuffs, and farmland are soaring.
In the past (1979-1980, 1994), runs on the U.S. dollar were contained by increasing interest rates and reducing the growth of the Fed's balance sheet. This, in turn, reduced the money supply while increasing demand for dollars (thanks to high interest rates). While I believe such policies would work again, I wonder how we could afford them today, given the total debt in the U.S. And that's a big problem.
We might not be able to stop a run on the dollar, simply because we're broke.
On a related topic... the Bank of America settlement with a group of institutional investors who'd bought Countrywide mortgage securities (for $8.5 billion) will only be the first in a number of such settlements. I've been talking about these issues for a long time. As I told you last August…
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There'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? |
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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... 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. |
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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 billion dollars 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. |
MBIA's shares jumped quite a bit on the news of the Bank of America settlement, even though the settlement didn't address MBIA's claims directly. We think the company's stock could still soar on further developments in the various lawsuits stemming from fraudulent mortgage underwriting. That's probably why the Fairholm Fund (run by Bruce Berkowitz) owns such a large stake in the company. I admit I've been unable to analyze the situation thoroughly because of the legal complexities involved in the large number of insured securities. I'd love to hear from subscribers who have firsthand knowledge of this situation.
You might regard the following as self-promotion… But I hope you'll read it carefully just the same. It might help you understand how paper money really works...
I might help you identify a good speculation to make on the ongoing mortgage crisis... But the best thing I have to offer you is a permanent relationship with my research company. I'm talking about becoming a partner of sorts in my firm. This offer, which will expire shortly, allows you to get all of our products (except for Phase 1 Investor) for one flat rate, plus all the products we will develop in the future. Many publishers have promised such deals in the past, only to renege in one way or another. We've taken the opposite approach, delivering more and better research products every year and giving all of them to our Alliance members. As a result, the cost to join the group has increased from less than $3,000 to more than $10,000.
I understand that can be an "eye-popping" number for some people. But think about it in a different way – especially if you're the kind of person who'd normally never consider spending more than say $99 on investment research. You see, I believe I can provide tremendous amounts of value to you once you've become a partner – or a permanent subscriber – to my business. Let me give you one example...
In October 2008, the world seemed to be coming to an end. The stock market was incredibly volatile, with much of the action coming as stocks plummeted lower and lower and lower. While many investors and advisors panicked, we did something I'm sure most people thought was slightly crazy: We launched a new advisory called Put Strategy Report. I wrote this advisory and promised people if they took my advice I could show them how to make a fortune off the crisis.
Our strategy? To sell puts on the highest-quality companies we could find that were selling for less than intrinsic value. We sold puts on Tiffany's, for example, in late January 2009 for $2 with a strike price of $15. These puts were so expensive, the only way they made sense was if Tiffany's stock traded for a negative number. Keep in mind, liquidation value of Tiffany's was more than $20 a share. And we were selling $15 strike puts for $2. There was simply no way we'd lose money on the deal. And in fact, we made more than 50% annualized on the trade. We did dozens of trades like this, and averaged gains of close to 50% on each trade.
Now... here's what I want to point out to you. If you were a regular subscriber, there's no way you would have ever gotten this information. I know, because we couldn't sell Put Strategy Report. Hardly anyone would buy it. People were too afraid to take action. It didn't matter how profitable our trading was or how many times I begged subscribers to try it.
But… ask our Alliance members about it. Dozens and dozens of them have thanked me profusely for taking my time to develop the product and basically shoving it down their throats. They would have never bought it. But because they got it as part of the Alliance membership, they saw how well it worked. They saw me explain the trades over and over and over. Nearly all of them made huge amounts of money.
In the end, I'm certain that my track record proves Put Strategy Report was the most valuable thing I've ever done for our subscribers. And I did it at exactly the right time, in the midst of a crisis, which helped our readers prosper during the worst bear market since the Great Depression.
Our offices are closed Monday, July 4 for the holiday. Look for your next S&A Digest in your inbox Tuesday evening. Enjoy your holiday weekend.
Regards,
Porter Stansberry
July 1, 2011
Miami Beach, Florida
P.S. Apologies for the lack of a mailbag section today. I'm off for a week of duck hunting with the Atlas 400 in Argentina. While you're reading this, I'm on an all-night flight to Buenos Aires. As a result, I didn't have timely access to "the bag." I'm not certain what my connectivity status will be ... So you might not get your regular Friday Digest from me next week. (No celebrating.) On the other hand, when I spend time with fellow Atlas members, I always pick up lots of good information and ideas. I'll share everything when I get back.