Into the abyss
Into the abyss... Bond market panic... Pirates to buy Citi... REITs collapse... A legend is coming to Hong Kong... The end of Wall Street... Richard Russell on the bear market... An overflowing mailbag...
It feels like we're slipping into the abyss... As you know, I thought the lows of October would hold. They haven't. And now, the panic seems to be moving back into the bond market, where this crisis began. October saw $31.4 billion leave bond mutual funds – the largest monthly redemption in history. And now, yields on 13-week T-bills have fallen back to zero. Institutional investors buy the 13-week T-bill as a kind of "parking lot" for cash – something that's always extremely liquid and totally safe. The more buyers, the lower the yield goes. This demand for 13-week T-bills matches the crisis-levels we saw briefly in September when Lehman failed and AIG was rescued. Has the government decided to let Citigroup fail?
Citigroup shares are down 47% this week – to less than $5. Saudi billionaire Prince Alwaleed bin Talal, a major Citi investor, tried to bolster the stock yesterday by raising his stake to 5%, up from 4%... Shares plunged 26%. Today, Citi announced it will consider options like selling the entire company to another bank or selling off parts of the firm, including the Smith Barney retail brokerage, the global credit-card division, and the transaction-services unit, which is one of Citi's most profitable and fastest-growing businesses.
The bank, along with representatives from other banks, is also lobbying the SEC to reinstate the short-selling ban on financial stocks. But the problem isn't short sellers. The problem is, the bank owes far more to its trading partners (credit default swaps) and depositors than it can hope to repay.
What will happen to Citi? Judging by the gallows humor of this phony news story circulating on the Internet, it doesn't look good:
Somali Pirates in Discussions to Acquire Citigroup
By Andreas Hippin
November 20 – The Somali pirates, renegade Somalis known for hijacking ships for ransom in the Gulf of Aden, are negotiating a purchase of Citigroup.
The pirates would buy Citigroup with new debt and their existing cash stockpiles, earned most recently from hijacking numerous ships, including most recently a $200 million Saudi Arabian oil tanker. The Somali pirates are offering up to $0.10 per share for Citigroup, pirate spokesman Sugule Ali said earlier today. The negotiations have entered the final stage, Ali said.
"You may not like our price, but we are not in the business of paying for things. Be happy we are in the mood to offer the shareholders anything," said Ali.
The pirates will finance part of the purchase by selling new Pirate Ransom Backed Securities. The PRBS's are backed by the cash flows from future ransom payments from hijackings in the Gulf of Aden. Moody's and S&P have already issued their top investment grade ratings for the PRBS's.
Head pirate, Ubu Kalid Shandu, said: "We need a bank so that we have a place to keep all of our ransom money. Thankfully, the dislocations in the capital markets has allowed us to purchase Citigroup at an attractive valuation and to take advantage of TARP capital to grow the business even faster."
Shandu added, "We don't call ourselves pirates. We are coastguards, and this will just allow us to guard our coasts better."
I asked our old friend Rick Rule what he thought was happening in the bond markets.
If I read this correctly, this is a continuance of the "convergence" trade. The assumption in that trade was that global risk was receding, and the long-dated obligations (which paid higher yields to accommodate a greater range of risks) would have rate "convergence" with shorter-dated instruments. These "time spreads" and "credit spreads" (a bet that the more risky credits were becoming less risky) became the stuff of leveraged long trades, like Long Term Capital Management. I never understood these trades or knowingly participated in them, although as a taxpayer, I guess I'm inheriting a bit of this trade after the fact...
The safest facets of commercial-mortgage-backed debt are now yielding 15% above benchmark interest rates, up from an 8.5% spread at the start of the week. According to Lisa Pendergast, an analyst at RBS Greenwich Capital Markets, investors buying at current yields will have all of their principal protected, even if all the pooled loans defaulted and offered "modest" recovery values.
As I've been warning, REITs are going to get wiped out. Dozens will go bankrupt. If the mortgage bonds on commercial real estate are yielding 15%, the equities paying those mortgages are toast. Now, you might want to do two things with this information...
One, sell short highly leveraged REITs – all of them. But the other thing you might do will make you a lot more money. You could form a new real estate holding company. Raise $500 million to a $1 billion in equity. Hire someone like Sam Zell to run the thing – someone who has lived through several real estate cycles, knows all the best properties to buy, and knows all the bankers.
As the REITs go bust, their mortgages will default. The bankers will have thousands of busted mortgages on their hands. They'll be losing money every month holding on to the underlying real estate. It'll be a disaster. That's when you show up with your new fund and $1 billion in equity. You offer to help the banks out. You'll buy the mortgages from them, at 10 cents on the dollar. And you'll be nice enough to allow them to lend you the money you need. You'll take the buildings off their hands and give them a performing loan at the same time. They'll love you. On your $1 billion in equity, you buy another $5 billion worth of properties – at 10 cents on the dollar. So you're really getting $50 billion in property with just $1 billion in equity. Within 10 years, you'll have $100 billion worth of property and annual rents approaching $10 billion.
I can't think of a better thing to do with a lot of capital right now.
So how would you actually do something like this? Well, most people can't. But Steve Sjuggerud and I know someone who can. He's an old friend – the man I told you about meeting with last week. Many subscribers thought I was just making him up (or thought I was talking about Jim Rogers).
Nope.
Our friend is one of the world's top three or four real estate investors, a man who has partnered with Soros and other elite financiers in New York. He knows all the bankers. He knows all the best properties. He's moving to New York for the first time since the early 1990s. He's starting a new fund, like the kind I described above. And... he's confirmed with us that he'll come to Hong Kong for our Alliance meeting on December 1. If you're an Alliance member, I hope to see you there.
Brian Sullivan, CEO of search firm CTPartners, predicts layoffs in the financial-services industry will accelerate in coming months, with job losses doubling to 350,000 worldwide by mid-2009. Reductions of that magnitude would equal 20% of the global financial workforce before the credit crisis began. "This is the financial equivalent of World War II," Sullivan said. "It's unprecedented. You're seeing a seismic shift in the population of banking. Without the massive leverage that's been in the system, the business of some of these big investment banks simply isn't going to be there. You'll go back to the investment banks of the 1960s and '70s."
I think Sullivan is right, but not right enough. The excesses we saw on Wall Street over the last 30 years really began in 1978 when John Gutfreund became Salomon Bros managing partner and took the company public. Salomon was the first investment bank to go public. The rest followed. This structure allowed the bankers to privatize profits, while hedging all of their risk with the public. Tails we win. Heads you lose.
This will never happen again – at least not for 50 years. The public will not invest in investment banks, private-equity firms, or hedge funds. All of the remaining public structures (Blackstone, Fortress, GLG) will eventually collapse or go private. And without the public to backstop the losses and the risks, leverage will be permanently reduced. Most of the activities of the financial sector are not profitable without lots of leverage. Financial sector employment will fall just as much as the leverage. And the sector will have to deleverage by at least 50% – probably more.
Mohamed El-Erian, co-CEO of PIMCO, manager of the world's largest bond fund, was interviewed on CNBC this morning. He said our current crisis "is a problem of the system... it morphs." It's ahead of the policymakers, which is why they have been unable to stem the problem. El-Erian was recently in the Middle East, which he said should be pouring into U.S. securities because they're so cheap. But it isn't. Nobody is buying U.S. securities because they want clarity. The government has already changed the bailout program twice, and investors are hesitant to buy without knowing the government's intentions. El-Erian closed saying the bond market is telling us "this is beyond a flight to quality. It's a flight to liquidity. It's about massive liquidation."
Here's something worth considering from Richard Russell, author of the Dow Theory Letters:
Since September, we have experienced ten 90% down-days. I think we are in an extended panic-crash stage of the bear market. Ultimately, we should see a huge counter-move rally – the "experts" will label this as "a new bull market." They will be wrong. It will be the rally that lures in the eager amateurs who are convinced (hoping) that the bear market is over. Actually, this bear market is now just one year old. I don't believe that a bull market that lasted 26 years can be corrected by a one-year or even a two-year bear market.
In the mailbag... It's overflowing with notes from subscribers. Thanks so much for taking the time to argue with us, to let us know how you're doing. We sincerely appreciate it. A good sampling is below. Don't miss the last note – a reader disagrees with me that the world probably won't end. If you've never sent us any feedback, why not give it a try? feedback@stansberryresearch.com.
"'This is a once-in-a-lifetime opportunity to collect enormous yields on corporate bonds because of overblown market fears. And you're guaranteed to collect your money – all the company has to do is stay in business.' The above was in the 11/21 S&A digest. I had a portfolio of junk bonds. Had I kept, I would have been down over 60%, with 20% of those defaulting. I held onto one, TOUSA, in hopes it might pay something, anything back. The $30k I spent on it is now worth $37.50. [Junk bonds are] a crap shoot, and I can testify to it." – Paid-up subscriber Steve D
Porter comment: It's not a crapshoot – it's a market. Default rates on junk bonds could go as high as 11% in a recession. But that means 89% of them will still pay off. And bonds have a legal obligation to pay their coupons – unlike stocks, which can cut their dividends. It's our analyst's job to find the almost 90% of corporate bonds that will pay off. To give you some idea of how big the opportunity in junk bonds is, consider that well-managed corporate bond funds are now yielding 40% and trading for about 50% of net asset value.
Mike Williams, editor of True Income, has some amazing corporate bond opportunities in the pipeline. You can collect enormous yields, and you have an almost 90% chance of retrieving your entire principal. Investing is a game of probability... and those are great odds. To learn more about True Income, which we're currently offering at a discount, click here...
"We are all suffering, and that is no kidding. The crazy thing about it is that I feel for all of you at Stansberry more than for all my own losses. The passionate desire on your part to help us by constant and excellent communications with us is admirable. I personally appreciate it very much and it gives me great comfort. In case that you think we do not notice your efforts to do just that, yes we do. There is not much that you CAN do in a market environment like no other. I am even grateful when I hear Jeff say: DO NOTHING. That is my opinion nowadays as well. So, thanks for the passion." – Paid-up subcriber Paula Zina
"In response to your request for more varied subscriber feedback, I'll tell you how my wife and I are handling this market debacle. I am a 71-year-old retired physician and thought I had a comfortable retirement program in position. I had used 'stops' in the past and almost invariably saw the stopped-out stocks recover in short order and move to new highs. So I maintained a diversified portfolio and decided to be a determined buy-and-hold investor. Holding good companies would allow me to handle the vagaries of the market.
"Well, I didn't anticipate the tsunami of this past year. I am now down about 50% and wondering if, indeed, I can hang on. I subscribe to several financial newsletters and value highly the advice from Stansberry Research. I hold most of the recommendations in PSIA and several from True Wealth and from [12% Letter editor] Tom Dyson. Assuming dividends are not cut too badly, we will have enough income to survive. But watching the steady deterioration of our financial position has certainly taken the joy out of retirement.
"I know you will holler at me for not using stops, but my past experience convinced me that they are just another form of market timing. Had I followed a 25% stop policy I would presumably have halved my loss, but would now be dependent on money-market income rather that dividends. In addition, it is unlikely that I would reinvest at the most opportune time to take advantage of the hopefully eventual market recovery.
"So, in summary, we are hurting and I feel guilty for putting my wife of forty-seven years in this position. Given the status quo, selling now does not seem like an option. I am planning to keep our diversification, follow your advice regarding buying good companies at low prices, and praying that future dividend cuts do not more severely reduce our standard of living. I empathize with the many who are in worse shape than we are. Thanks for the great service you provide. I wish I could afford the Alliance membership. If I live to see a market recovery, I'll sign up." – Paid-up subscriber Donald A. Barnhorst, M.D.
"I was in a rut. Buy a stock. Watch it drop 25%. Sell the stock. Repeat multiple times. What should I do? A book I ordered in the springtime, The Gone Fishin' Portfolio (GFP), finally arrived in late August. I also subscribed to the S&A Private Wealth Alliance in August. Included in the subscription was the now defunct Monthly Dividend Program (MDP). Aha! I thought after reading this material, I'll sell the stock in my 2 IRAs and invest in these two plans.
"I created 3 watch lists: One for the 10 GFP funds, One for the 10 GFP ETFs, and one for the 10 MDP recommendations. On 9/11/08, I sold all of the stocks in my IRAs. I continued monitoring my watch lists and did not buy. To this date I have only cash. The 2 GFP watch lists were created 8/29/08. All 20 investments are negative. In fact 17 of the 20 investments have hit the trailing stop. The GFP Fund portfolio is down 43.6% and the ETF portfolio is down 32.3%. The MDP watch list was created using a date of 6/27/08. All 10 investments are negative. Only 1 has not hit the trailing stop. The portfolio is down 47.3%. I read that value companies are good investments at current prices but they keep dropping also. The S&A Digest recommendations of 10/24/08 are down 21.3%. I was able to track 24 of the recommendations. 16 are down with 4 hitting the trailing stop (including even BRK.B).
"So I'm in a watchful waiting mode. I'm retired so I don't want to wait 10 to 15 years for the market to turn around. The last 10 years resulted in a net loss. I used to be hesitant to withdraw money from my accounts. But my philosophy is changing. I would rather spend the money myself instead of losing in the stock market; having inflation devalue it; or having the government grab it." – Paid-up subscriber Don Currier
Porter comment: I'm certain almost all of our readers can relate to Don's experience. If the market continues to fall, I think most Americans will come to believe the stock market is nothing more than gambling, or worse, it's rigged. The equity culture built since the mid-1980s will disappear. Buy-and-hold strategies – and the people who pitched them – will be totally discredited. One good thing is likely to happen along the way. Public companies are going to be cleaned up – finally. Most public companies are a spectacle. It's the foolish leading the blind. Oracle is a great example. As I explained in my newsletter, PSIA (February 2007):
Look at Oracle's board of directors and you'll find one of the true collections of patsies in all of corporate America. Three directors owe their careers to Ellison as executives at Oracle. Two board members are professors from Stanford with zero real-world business experience. There's Jack Kemp, a failed politician. Two former venture capitalists and a partner in a tech research firm. But my favorite is Jeff Berg – a Hollywood talent agent. That's who Ellison put in charge of his compensation, a Hollywood talent agent whose job is to get big paychecks for his clients. Berg is the chairman of the compensation committee! Ellison might as well be governed by my grandmother for all of the restraint and backbone these directors are likely to display... Oracle is one of the prime examples of how shareholder capitalism can lead to a spectacle. No sane person can look at Oracle and not gawk in wonder. How did the customs, norms, and laws of our country become so perverted? Why would a company that's owned by thousands of shareholders be allowed to shower billions in compensation upon one man?
This is what happens during bear markets: The excesses of the past are wiped away. Over the next few years, I believe we'll see a real revolution in the way public companies are run. And that – perhaps more than any other factor – will produce much better returns in the future.
"I have been a subscriber for getting close to three years now, and I do not currently hold any of S&A's recommendations. I also read Chris Weber and Casey Research, so since I am very under water in my mining and energy picks from Casey, I am mitigating the damage with a sizeable position in GTU (the canadian gold trust managed by John Embry) and working on accumulating cash for now. I think Chris Weber is right that cash and precious metals are the smartest places to be until the deflation/inflation cycle we are in plays out, or at least until there is a big enough run up in the inflation assets (metals, commodities and energy) and equities are so nasty cheap that its time to play like Jim Rogers and start migrating back into equities once they are pronounced dead again by Newsweek or Time or the WSJ and the proverbial Golden Bull is tearing through the stock market on the cover of one such financial publication as well.
"I agree with Jim Rogers that we are in the correction of a longer term commodities up/equities down 14-20 year cycle and I am sticking to my guns. I am working on generating cash flow by doing hard money lending with and through people I know personally who are very good at it, very smart, and who have a high level of integrity. There is still risk but I mitigate it by dealing with good people with a good track record who know how to make things happen and get things done. I plan to accumulate cash through this avenue and primarily build up the level of cash in my overall portfolio, while 'nibbling' and accumulating more metals & energy equities that are way undervalued in preparation for the run-up sometime in the next year or three. I will continue to subscribe to S&A because when the time comes to buy equities again I know you guys do great research and I trust you to give me your best ideas. I have not had the guts to short anything yet, and I don't know if I will, but I am open to it and may still yet depending on how things go.
"What I really appreciate about S&A as well as Casey and Chris Weber (which I found out about through you, so thank you for that) is that I know all of you are straight shooters, keep a level head, are very competent and well informed. Most of all, because I know I can trust you, you help me keep a level head while we're on this rollercoaster so that I don't do something stupid like try to bail and hurt myself while the ride is still going. That one thing is invaluable. To keep one's sanity in a time of general insanity is priceless. Thank you for that. That alone is worth the price of the subscription. The education I am getting from and through you is also worth many times more than my subscription fees. Just knowing I am not alone or stumbling blind through this era is huge for me, and the fact that we are living through economic, political and social history in the making is not lost on me either. We are the builders of the future and I believe we will create a better world while the lessons of history play out and truth eventually will rise to the surface regarding what really works and what does not work in the arena of human civilization and and economies. Have a fantastic day, and keep shining on!" – Paid-up Private Wealth Alliance member Chris Guenther
"It remains incomprehensible to me, that you continue to slam the domestic automakers, suppliers, dealers, you and me. Yes, we are all in it together. No matter what we do in this country, presently there are many corrections and adjustments occurring. Yes, the autos have been flamboyant to a degree. What of your industry? Lets look at NYC right now. Office rents collapsing, unemployment rising, fine restaurants sitting empty. A result of paper traders no longer able to spend their investor's money. If I don't work, I can't subscribe. Your subscription base shrinks, then all of you financial prognosticators sit home as well. Don't bail out the autos and watch the national repercussions. Interesting on how the disciples of Wall Street stole, borrowed and then begged for bailouts while producing nothing but paper and stock investor paupers. Even your publications have guaranteed nothing except to let the subscriber beware. Autos guarantee America jobs, dependable incomes and a mode of transportation that all of us enjoy and depend upon. Will all of us then become paper traders? Or newsletter writers? And what market industry employees will be around and capable of carrying America forward?
"Maybe everyone should follow 'the string' of entities and industries that will suffer with the autos so as to fully understand what will be lost. Maybe your newsletter business can expand to accommodate around 3 million more people who will be desperate for a job. You offer many 'slams' with no alternative replacement industry ideas and if you do have an answer, government, business and every person in this country will revere you, as the greatest prognosticator and problem solver in history. Your work is respected and I enjoy your writings, but the demise of America has more to do with 'your industry' than all others combined." – Paid-up subscriber Gary S. (Detroit)
Porter comment: I have never criticized the domestic auto industry – which includes BMW, Toyota and Honda, companies that make as many cars in America as Ford, GM, and Chrysler. I have been relentlessly critical of General Motors because the company operated at a capital loss for 19 of the last 20 years. It has built cars that can only be sold at a loss. It has paid its employees not to work, and perhaps worst of all, it paid out dividends from money it borrowed – ponzi finance. When GM, Ford, and Chrysler fail, all of that capital and all of those people will be able to do something more productive. That will be a terrific boon for Detroit and America. If those companies are propped up – with still more debt – they will still fail, eventually. In the meantime, more people and more capital will have been wasted. Propping up these companies also makes it more difficult for the truly competitive carmakers in America to earn a profit. Imagine the autoworkers in South Carolina. Why should their taxes be used to aid their competitors? That's not the proper role of the government.
"As a long time union member (AFL-CIO), I used to back the UAW. However I have changed my tune. When I found out they were making twice what some of us in the building trades were making I realized that enuf is enuf. What they do on the line is not to be considered 'skilled' labor by my standards. I've had to go through a five to six year apprenticeship and years of OTJ training to pass my journeymans exam. Their wages have given unions a bad name for too long! It's time they started earning what they are really worth. I say it's as good a time as any to restructure the whole buisness model from the CEO's down to the line worker. America and the auto industry will be better for it." – Paid-up subscriber Raymond
Porter comment: This should be obvious to every American. So why is it not obvious to Congress?
"Mobtown? Hey Porter, what's under that skirt of yours? The same guy who will call out anyone and everyone including the U.S. Government and the SEC is afraid to stand up to some dip sh** who can't set up a tent? Maybe you can get your buddy in New York to loan you a couple of his bodyguards after you tell the tent guy to go pound sand. But honestly, I think you should be more worried about all the sniveling union workers from GM that are probably pissed off about your letters [from] the chairman that were so very entertainig, yet so very true..." – Paid-up subscriber Mike Pearson
Porter comment: I'm sure most of the union guys think I'm right. And they don't know where I live. The tent guy does.
"I've been in full-time ministry for over 7 years and I'm excited about the times. Bible prophecy is coming to pass like crazy and we're approaching the culmination of this thing called the 'Age of Grace' or the 'Church Age.' If I had to guess (and no one knows exactly, although we understand the times), I'd say we're no more than 25 years from the return of the Lord... There's so many more urbanites than ever before and there are so many more people who are neither equipped with the knowledge or resources to survive in a famine of resources, which I believe will accompany this next 'great depression'... It's gonna get even more interesting to say the least, but I'm ready to meet Him. Are you? Are all your readers? I enjoy reading your takes on the economy. It's fun." – Paid-up subscriber Alan Church
Porter comment: I'm willing to wait.
Regards,
Porter Stansberry
Baltimore, Maryland
November 21, 2008
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Pub
Editor
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237.1%
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154.1%
PSIA
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137.7%
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