Next Up in the Dead Pool... National City and Wachovia

What's happening to the banks... Wachovia next?... Barney's bailout emporium... What to do now... The WaMu numbers... God hates short sellers... Why Berkshire?... The difference between gold and paper... The next floater...

If you want to thoroughly understand the problem plaguing banks and brokers today, you ought to go back and read a Digest I wrote in August 2007. Unfortunately, just about everything I feared might happen has come to pass.

As I explained in that essay – over a year ago – what's happening is a massive deleveraging of the global financial system. A global run on the bank. It's hard to know what will break next, but the Goldman fundraising and the failure of AIG have convinced me it's going to get worse, probably no matter what the government does.

Goldman wouldn't have cut the deal it did with Buffett if it had any chance of surviving without a massive amount of additional capital. That means Goldman's "marks" – the value of the assets on its balance sheet – are not nearly as good as it claims. (That should be no surprise to you, as that's what I've been expecting all along.)

The failure of AIG means the credit default swap market – global credit insurance – has been completely destroyed. That's why the LIBOR (the main international interbank lending rate) keeps rising. All the banks know their peers are at risk of failing, and they have no way to insure credit risk anymore.

It's a mess. And a lot more banks are going to fail. Wachovia will be next. (Check Dan's essay, below, for more on Wachovia.) Then Morgan Stanley. These firms can't possibly sell their assets at any reasonable price.

Won't the government bailout solve all these problems by giving these firms cash in exchange for their mortgage assets? I doubt it. As you know, WaMu failed last night. Its doors wouldn't have opened today if JPMorgan hadn't bought it for $2 billion. As part of the deal, JPMorgan will write off over $30 billion in mortgage assets. At current prices, selling its mortgage portfolio to the government wouldn't have saved WaMu.

Won't the FDIC protect us? WaMu failed with $188 billion in deposits. That's four times the entire FDIC reserve. And how many banks can JPMorgan and Bank of America afford to buy? Or will the government come in and pay full face value for mortgages now trading for less than 10 cents on the dollar? That's hard to imagine. How will the government raise $2 trillion in cash? What would happen to the value of the dollar?

If you're counting on the government bailout to work, you're putting your trust in the hands of Barney Frank and Chris Dodd, the men who brought you Fannie and Freddie's ever-expanding balance sheets and pushed no-down-payment lending onto the mortgage industry. These guys are complete clowns. Together, they're the two worst financial bunglers in the history of our government.

What should you do? Honestly, our advice hasn't changed:

You should own physical gold and silver (up to about 10% of your assets).

You should own high-quality, blue-chip operating companies, like the kind I've been recommending in my newsletter, PSIA (up to 40% of your assets). These firms can protect you from inflation because they'll be able to raise prices and increase their dividends. You should consider selling calls against these positions (as we've done in my letter) to generate income and hedge against any temporary price declines.

You should own carefully selected corporate bonds (up to 40% of your assets), if you can buy them at a substantial discount to face value. The bonds you buy should only be from companies with solid assets that you can understand.

You shouldn't hold much cash – no more than 5% of your assets – because the dollar is very likely to depreciate. Current interest rates aren't keeping pace with inflation.

We wrote it, did you short it?

As a thrift, WaMu is loan-driven, not deposit-driven. Its sole reason to exist is to expand its balance sheet through lending funded by expensive CD deposits and Federal Home Loan Bank advances... If I had to name a big bank that will fail in the next several months, I'd pick WaMu.

– September 2008 Extreme Value

The FDIC seized Washington Mutual and sold the bulk of the business to JPMorgan Chase in what is the largest U.S. bank failure in history. WaMu failed after depositors withdrew $16.7 billion since September 16. JPMorgan paid $1.9 billion for WaMu's banking business and will absorb its $307 billion in assets. It will immediately write down $31 billion in assets and raise $8 billion in fresh capital. JPMorgan is now the largest U.S. deposit holder and second-largest financial institution behind Bank of America.

Apparently, God hates short sellers, too. This from the Financial Times: John Sentamu, archbishop of York, called traders who cashed in on falling prices "bank robbers and asset strippers."

Former AIG chairman Hank Greenberg is finally dumping his old company's stock. Greenberg sold 5 million personal shares and 35 million through his Starr International Co. investment vehicle. He pocketed $126 million from the sale... The shares were worth $2.68 billion last year. Greenberg still personally owns over 34 million AIG shares. He and his affiliates collectively own 355 million shares.

If you've begun to doubt the wisdom of the folks running the largest financial institutions in America, consider what Eugene Belin, Citigroup's head of fixed income in Moscow, said yesterday about Russia: "Russia was considered a safe haven but now people are realizing it's no safe haven whatsoever..."

We note only 10 years ago Russia defaulted on its national debt. We also note its government has repeatedly plundered private companies, thrown its political opponents in jail, and murdered journalists. If Citigroup ever thought Russia was a "safe haven," it's not hard to figure out how the company lost $100 billion in mortgages.

S&A FDA Report readers just made huge profits on Dr. George Huang's recommendation of Indevus (IDEV). The company received great news from the FDA regarding one of its lead drugs and landed a partner for another. Shares soared on the news. Subscribers have made almost 90% since July. To learn more about the S&A FDA Report and which trades George is watching today, click here.

New highs: none.

In the mailbag, readers want to argue with me about accounting. What could be more fun? Send your arguments here: feedback@stansberryresearch.com.

"Why do say Buffett is only $1.8B exposed? He bought a $3.2B option from Goldman. While it is unlikely, Goldman COULD close below $115 in 5 years – in which case Buffet's option expires worthless. Maybe his mark-to-market exposure is $1.8B today – if he turns around and sells the option today. If he holds, his exposure may be greater. If his $3.2B option value was not exposed, that would mean that whenever I buy one of Jeff's options recommendations for say $5k, that $5k is not "exposed" as at the time of purchase, based on Jeff's excellent analysis, the likelihood of the option expiring worthless is very low. But in my book, guess what, I'm still exposed to the tune of $5k, until I sold the position. Please elaborate if you see it differently." – Paid-up subscriber Michael Bauer

Porter comment: You've got it all wrong. Buffett didn't buy the warrants. They were given to him for free. He received warrants worth $3.2 billion. He bought perpetual preferred stock with a face value of $5 billion and a 10% coupon. That's why I said his true net exposure is only $1.8 billion. And although I didn't mention this in my earlier analysis, the free-market value of his preferred shares is probably closer to $7 billion. So, net-net, Berkshire was paid to take a 10% stake in Goldman.

"Buying Berkshire Hathaway doesn't make sense to me, unless you're very young and/or don't need the money. It doesn't pay a dividend, and it doesn't have options, so there's no way to hedge your investment and no way to realize that ten percent a year without selling the stock. Am I missing something?" – Paid-up subscriber Patti

Porter comment: Why on Earth would you want to hedge your exposure to Warren Buffett? You're certainly missing something, Patti, but I honestly don't even know where to begin to explain this. Try reading Dan's thorough recommendation of Berkshire in Extreme Value. If you're not a subscriber, click here.

"There is a lot of talk right now on the subject of buying Gold. I received a email just today from Jeff Clark stating the same. Can you please tell a young investor how to buy gold and to clarify the difference between buying actual gold and buying gold stocks? How do I buy actual gold? And lastly what would be some good gold stock plays to consider?" – Paid-up subscriber Scott Brooks

Porter comment: Pick up the yellow pages. Look up "Broker, Gold" or try looking under "Bullion" or "Gold Coins." Call the numbers you find. Ask them what their price is on gold bullion. Buy from the guy with the best price, assuming he's been in business in the same location for a long time. If you're nervous about whether or not it's real gold, ask a jeweler. If you don't have a local gold dealer, call the folks we know: David Hall, Camino Coin, or Asset Strategies International.

As for your second question: One is a piece of paper; the other is a lump of metal. For which gold stocks to buy, I'd recommend reading our own Matt Badiali, Doug Casey, or John Doody.

Regards,

Porter Stansberry

Hatteras, North Carolina

September 26, 2008

Next Up in the Dead Pool... National City and Wachovia

By Dan Ferris

Financials are slopping up to the discount-window trough at record levels.

Courtesy American Banker

Sooner or later, the Fed will monetize all the bailout money, including $700 billion of additional debt Congress is debating right now. That means the Fed will create checkbook money to buy it. That's what is at the bottom of all this.

Buffett alluded to it the other day, saying the Treasury "can borrow unlimited." It can borrow unlimited not because the taxpayer can pay unlimited. He can't. And it's not because foreign governments will lend unlimited. They won't. The Treasury can borrow unlimited because the Fed can buy unlimited, because the Fed, like all central banks, has a monopoly on note creation.

The stampede to the discount window, the stampede to the Federal Home Loan Bank (like we saw at WaMu)... the same "safety valve" is at the bottom of it all: The Fed's money creation power.

Take a look at the share prices of financial holding company National City Corp. (NCC) and Wachovia (WB). These two are the next big risks for failure. Remember: Wachovia bought Golden West at the top of the bubble in 2005. It's just like Lehman buying Archstone-Smith at the peak. These deals are the failure flags. They tell you which managements really drank the Kool-Aid on perpetually rising real estate values (or which didn't care… or which ones were criminals). Wachovia is holding something like $122 billion of option-ARMs.

National City has $101 billion of deposits. Wachovia has $449 billion of deposits. That's $550 billion... more than seven times the FDIC's capacity ($45 billion reserve + $30 billion Treasury line of credit = $75 billion). That $75 billion is understated, since premium payments will be coming in. But is it understated by that much? The FDIC took in $3.2 billion of revenue in 2007. About $2.5 billion was interest on Treasuries. Only $640 million was premiums. When the failures wipe out the FDIC's Treasuries... then what will it do? It can't possibly raise assessments enough to make up for the shortfall, even if the only two banks to fail are NCC and WB.

I realize this is a bit theoretical, as we saw with WaMu. It didn't tap the FDIC. But how many deals can the FDIC broker to keep from having to pay off insured deposits? Those deals will only get harder to do. And we'll see more banks shouldering up to the trough.

I don't know of anyone in the regular media who's harping on this nearly hard enough (if at all). They all keep talking about the burden on the taxpayer, as though anyone is actually going to pay off the huge debts our government has taken on and continues to take on. Those debts won't be repaid. Such debts never get repaid. That's the lesson of history. That's why they shaved metal off Roman coins.

Gold will hit $2,000 next year, and no one will see it coming. Yes, the deleveraging liquidations will continue, and cash and money-market balances will keep rising. But gold is a very small market. Just a little of those trillions of cash can shove it to the moon pretty quick. From today's level, it could easily spike to $1,100 in a day or two.

Good investing,

Dan Ferris

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