S&A Digest: A truly colossal screw-up

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(Top 10 highest-returning open positions across all S&A portfolios)

As of 06/19/2013

A truly colossal screw-up... Freddie to raise $10 billion, don't laugh... Muslim allies... Barney Frank cashes in... Pelosi's ethics... The Vegas gambit... Fannon calls it... The twin titan of corporate infidelity... A great mailbag and my ego...

Rarely in all of human history has there been a more colossal #$%@-up than the situation at Fannie Mae and Freddie Mac. Backed with a guarantee from the government and freed from the capital restrictions of the banking industry, the managers at Fannie and Freddie bought roughly 50% of all the mortgages made in the United States from 1990 through 2003. Their mortgage holdings increased from $136 billion in 1990 to more than $1.58 trillion – roughly a 100-fold increase. Hardly anyone figured out it was the very credit produced by Fannie and Freddie that was sending home prices soaring and supporting the entire U.S. economy. Meanwhile, America woke up after a 10-year housing binge saddled with debts it can never afford to repay.

So what happens now? Well, consider what the companies' former regulator told the Wall Street Journal today: "At the heart of this crisis of confidence is uncertainty about the true financial condition of the companies."

The truth: The companies' accounting is so notoriously bad, the companies themselves don't know within several hundred billion dollars what their assets are really worth. On the other hand, estimating the value of their books isn't hard to do. We know Fannie and Freddie own more mortgages – of all types – than anyone else in the world. While they don't disclose much about the condition of their portfolio, we know from Countrywide's results the news must be disastrous. Countrywide was the second-largest owner of U.S. mortgages, so its results ought to be at least comparable. As of April 30, nearly 48% of Countrywide's non-prime loans were in some stage of foreclosure. Nearly 21% of its prime adjustable rate portfolio was in some stage of foreclosure.

My best estimate of Fannie and Freddie's book is that around 20% of their loans and their guaranteed loans are in some stage of default or foreclosure. It's a rough guess, admittedly. But it must be closer to the real number than the number Fannie and Freddie have admitted so far, which is less than 1%. That's laughable. More than half of their book was originated later than 2005. Fannie and Freddie expect you to believe their loans are like the kids at Lake Wobegon, all above average. But they own half the market – their loans can't all be above average. If you assume a 75% recovery on these defaults (which is incredibly optimistic given most real estate-related distressed sales are going off at 40% of peak value), then Fannie and Freddie ought to lose something around $250 billion. It's certainly possible they could lose twice as much. Easy.

All of which makes Freddie's plan to raise $10 billion in preferred stock an exercise in bad humor. A $10 billion preferred stock offering would require an additional $1.3 billion per year dividend payout, assuming the interest on the new shares is equal to the interest on the existing preferred, which has been wiped out by the crisis. With losses of $11 billion so far, how would Freddie pay anything, much less more than a billion? It can't. The common stock is already worthless. Folks just haven't accepted it yet.

And by the way, foreigners are finally waking up to the risks of buying U.S. assets – even those backed by the federal government. Kuwait – that wonderful little Muslim dictatorship we saved from Iraq – is selling its dollars and will no longer buy any U.S. agency debt (i.e., Fannie and Freddie's bonds). Nothing like a Muslim ally...

Noted statesmen and former owner of a gay bordello, Barney Frank (who happens to chair the House banking committee) is using this crisis to push through his $3 billion gravy train. The bill would create "block grants" – essentially a slush fund for politicians – that would be funded "off balance sheet" by taxing Fannie and Freddie's mortgage holdings.

Bush had threatened to veto the bill because of this rider, but the crisis at Freddie and Fannie now make that impossible. Also, under cover of the crisis, our dear friend Nancy Pelosi repealed most of the new ethics rules passed to great fanfare on the Democrats' first day in power. Of course, the rollback of lobbyist disclosure rules happened late last night, when hopefully no one would notice. These are your elected officials, dear subscribers. Aren't they noble?

Vegas is a city worth watching – a sort of litmus test of the economy. When I was there last week, the cab drivers all told me the same thing – business had died about a month ago. It was the worst it had been since just after 9/11. Currently, $23 billion worth of development there is due to be completed by 2012 – including Kerkorian's mammoth $9.2 billion CityCenter. Meanwhile, Starbucks is closing more locations (13) in Vegas than in any other U.S. city.

And the noted real estate investor, Nicholas Cage, is trying to sell his $9.9 million Vegas home. On a 0.3-acre lot, the Cage "pile" features parking for 16 cars, 14,000 square feet "under air" as they say, a pool, an elevator, and views of the Vegas strip. He bought the place in 2006 for "only" $8.5 million. I wonder how much gambling the average U.S. homeowner will do now that he can't refinance his mortgage... or even pay it? And what happens to Vegas when no one can afford to fly there anymore because U.S. airlines have raised fare prices so much?

We wrote it, did you short it?

Capital One is particularly vulnerable to a surprising amount of bad debt, simply because it has grown aggressively over the last five years. Loans held from investment have grown from $32 billion to more than $100 billion today. I humbly suggest the decline in credit quality over that period will prove to be substantial. Its loan book grew in excess of 20% every year between 2003 and 2007 – about six times faster than the economy. Meanwhile, the quality of its loans noticeably declined. As the quality of the company's loans has deteriorated, so has net income... The write-offs have eaten more and more of its profits. Loan losses totaled $1.4 billion in 2006 and $2.6 billion in 2007... I predict over the next 12 to 18 months, Capital One experiences defaults on more than 10% of its total loan book, resulting in losses of around $15 billion. That would erode a majority of the bank's equity.

– PSIA April 2008

Yesterday, Capital One announced second-quarter profits fell 40%. Its charge-off rate increased 14 basis points to 4.87%. The company expects "additional credit pressure" in the future due to a deteriorating U.S. economy. Shares fell more than 3% this morning, and readers are up more than 16% on the short recommendation.

PIMCO's Bill Gross is bearish on the euro... the Bond King says the currency is overvalued 30% in relation to the dollar. A panel of Bloomberg analysts expects the euro to be lower against the dollar, yen, and pound by January.

The two twin icons of corporate infidelity, Merrill Lynch and Citigroup, both reported earnings yesterday. Citi lost $2.5 billion, including $11.7 billion of write-downs, and a 29% decline in revenues. Merrill lost $4.6 billion, including another $10 billion in write-downs. All of the misfortune couldn't have landed on two more deserving targets. These are the same two companies who touted the shares of Enron to their clients while, at the same time, helped the crooks cook their books, turning loans into revenue. I hope both end up as zeros. And they probably will.

We wrote it, did you buy it?

The fundamentals of the generics industry have not changed. The industry has three to five years of explosive profits ahead thanks to a slew of blockbuster-drug patent expirations. The demand and the profits are all there. Barr will ride the wave of patent expirations along with all its generics peers. In conclusion, if you haven't established a position in Barr yet, take advantage of this chaotic reaction to do so now. Shares of Barr for anything less than 15 times adjusted earnings – or $41 per share – are an absolute bargain.

– A May 8 Phase 1 Investor update

Teva Pharmaceutical yesterday announced it would buy Barr for $7.5 billion. Shares are up 34% since Wednesday. Rob Fannon advised readers to buy the stock in May after a rough patch... Phase 1 readers are up 66% since then.

New highs: Baxter International (BAX), HeartLand Express (HTLD).

In the mailbag, an overwhelming number of subscribers who actually saw my Vegas speech applauded my x-rated ranting against the unmitigated evil of our central government. But... a few subscribers disapproved. A sample of both sides is below. Also, dozens of you have inquired about where to find a transcript or a recording of the speech. My answer? Beats me. I don't know if it was recorded or where to find a transcript. Try looking on the web, under "FreedomFest." Send your feedback here: feedback@stansberryresearch.com.

"Whose Ass is blacker? I'm just a dirt farmer from South Carolina. My wife and I have never been to sin city and I thought it would be a good time to go and listen to anyone that was going to talk about Freedom. I'm not long in words and don't type any, so this is special! Mr. Porter if those people didn't like what you told them about America then they are missing the boat and don't have to deal with governments and their restrictions as I and you do. The truth is not in them! I was the first to greet you as you came off stage. Your hang-over and your $5000 was well worth my poor ass time! Keep preaching and if I can help let this dirt farmer know." – Paid-up subscriber "Billy"

"Hi Porter and All- I took my 19 year-old son and my son-in-law to FreedomFest and loved it. It opened up the kids' eyes a lot about what true freedom is, isn't, and what it could be if we didn't have politicians messing with us and our money. The highlight of the show wasn't D'Souza and Hitchens – it was Porter. A month ago, my son said that the best way to fix the current political and fiscal situation in the U.S. was to 'get rid' of all of our current politicians. He felt very self-righteous and vindicated after Porter's comments! We were among the very loud applauders at the end of your talk. We hope that you will be invited back to FreedomFest and that you will accept and not hold back the truth (again!)." – Paid-up subscriber Paul Kirkegaard

"You are pompous, brash, loud and of somewhat a neophyte in ability to express yourself in an effective way – sorta like Patrick Henry – hope you will stick to your tact until you perfect it! But you have made more for me than most of the other investment guys – so at least you do something right!" – Paid up subscriber Scott Butler

"Porter, while I think you are a good analyst and made some great calls such as Fannie and GM, you go off the deep end on political issues. I think you would have more impact on your audience trying not to be so 'descriptive' about politicians and their lack of character. Politicians are easy targets but unfortunately, we elected them. That is the downside of a democracy. Your blood pressure and blood alcohol content will stay down more if you realize they are generally stupid, selfish, arrogant, corrupt, and soulless. See, you can say the same thing you did in Vegas without swearing so much that you aggravate the audience. Your speech had some great points but you will lose the audience when you sound like a so-called Hollywood entertainer. Yes, I was at Vegas and wanted to see who you were." – Paid-up subscriber Kurt Swogger

Porter comment: Excusing the politicians because they're elected is like forgiving a wife-beater because he loves his wife. The evil men in Washington have wrecked our economy, destroyed our currency, and created a culture of entitlement and excuses – not to mention what's happened to everything else in the public sphere, from schools to roads. They deserve every foul word I uttered, and many, many more. If things end up like I think they might, my words will be the least of their problems. The American people are well-armed... and will have a right to be angry.

"I was in attendance at FreedomFest and heard your speech with all the colorful language to punctuate your frustration with our broken system and corrupted politicians. As a seasoned citizen, I have heard worse language in my weekly golf foursome. While I'm sure some were offended, screw 'em. Hard times call for hard words and hard actions. I asked you at the conference what we can do to right the ship and fix the system. While your solution would put one in jail rather quickly I had a good laugh and would highly recommend a book written by Vince Flynn titled Term Limits in which politicians do start showing up dead on a frequent basis. As you can imagine, it got Washington DC's attention. All the Vince Flynn books are great reads. Let's hope we can change the system without such drastic measures taking place..."

– Paid-up subscriber Kevin Desmond

"One word = Balls. I really appreciate you having the balls to stand up and let people know what you think. I have gotten to the point where I've worked hard in this country, paid a lot of taxes, paid a lot of Social Security only to watch the US Government squander it away in their blind arrogance. I'm so disappointed in the way things are headed and the fact that the NEXT credit crisis we face will be the debt burdened folks across this country that will further pull the entire system down as they will simply walk away from their financial obligations causing yet another round of write downs.... Don't get me wrong, I VERY MUCH love this country but to see the way the American people are being exploited by the government. Our Founding Fathers would be absolutely disgusted at this point..." – Paid-up subscriber John Gault

"You should be tarred and feathered there at stansberry research for all the rumors you started and added to for the equities that went up, the commodities you recommended and the gull of you for making subscribers money, as that is not in the interest of our gov't liking. Only their favorites are allowed to make money. After all the years you've been in business, has there been a time when the small man made a great return without the regulators or some government facet crying about it. Keep up the talk as you did in tonite's digest, Porter, and you'll have me as a follower from now on. Thank you for saying what you think. Hope you don't get into trouble over it."

– Paid-up subscriber S Walks

"I didn't hear or see your speech, but I laud you for it. Probably perfectly described the politicos. But I think I smell a lot of ego coming from you, as well. Power comes in many forms, and it feeds the ego. I like your work, believe you have good insights, but see your ego alive, well, and outsized." – Paid-up subscriber Robert Rush

Porter comment: My wife would certainly agree with you, Robert. Writing itself is an act of ego. And you certainly have to have a strong belief in yourself to be successful at picking stocks, as the market is designed to make as many people as possible look as stupid as possible. I try to limit the number of things I'm willing to comment about to the things I've personally researched and understand thoroughly. I'm very humble about everything else. You should see me try to play golf, for example. Talk about humble.

Regards,

Porter Stansberry

Baltimore, Maryland

July 18, 2008

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