S&A Digest: Bank of America reports "earnings"

Bank of America reports "earnings"... Filipino prisoners dance... Too crowded on the short side of the market... Stock tips from the pros... More trouble for homebuilders... We're irresponsible on Freddie and Fannie...

This week we should start with good news... Bank of America is still profitable! That's no small accomplishment given the size of its credit losses. Revenues in the last quarter grew 4% to more than $20 billion. Profits (net income) totaled $3.4 billion. Sounds good, doesn't it? Do you want to know more? Or would you rather just believe the good news?

Here's the rest of the story: Bank of America increased its provisions for credit losses by $4 billion from a year ago, to nearly $6 billion. This is the amount of money Bank of America expects to lose, eventually, from defaults on its loan portfolio. The amount actually charged off this quarter was $3.6 billion – or 1.67% of its entire book. (If Fannie and Freddie lost a similar amount on their portfolios, they'd be insolvent because of the extreme leverage they employ.)

You ought to know two more things about Bank of America's results. First, they didn't include credit losses from either its LaSalle mortgage unit or Countrywide Financial. Where did these losses go? We're not sure. Bank of America bought LaSalle for $21 billion in cash last October. It's hard to imagine it didn't overpay by at least $10 billion. It hasn't taken any write-offs here yet – but it will, I promise. Bank of America bought Countrywide for around $4 billion in stock July 1. Countrywide lost $2.3 billion in the last quarter, including $4 billion in mortgage write-downs. Countrywide's losses alone would have nearly wiped out Bank of America's entire quarterly profit. Not surprisingly, Bank of America didn't mention this fact in its press release...

What else should you know about Bank of America's "earnings"? The company doesn't mention the extent of its off-balance-sheet guarantees to so-called "structured investment vehicles" (SIVs) – the investment companies set up specifically to invest in mortgage securites. These aren't really even companies at all, they're merely vehicles for holding mortgages on a highly leveraged basis.

The deals work like this: An investment banker raises a small amount of equity – maybe $10 million – and creates a company. We'll call it "U.S. Mortgage, LLC." U.S. Mortgage then borrows $100 million via the commercial paper market, which offers 90-day senior loans. To get the best possible rate, U.S. Mortgage needs a good credit rating, which, of course, it should never be able to get. So U.S. Mortgage pays Bank of America a fee for guaranteed access to Bank of America's credit – a "backstop" funding agreement. In other words, if for any reason, U.S. mortgage cannot get funding from the commercial paper market, then Bank of America must provide whatever liquidity is necessary to maintain the mortgage portfolio – even if the value of those mortgages is highly suspect. If the portfolio falls in value, Bank of America takes a loss on these loans. If you assume the typical SIV has lost about 20% on its portfolio, that's $20 million in losses. The equity investors are wiped out and Bank of America is taking a hit, too.

How much money is at risk? According to Bank of America's annual report, it had at the end of 2007 $104 billion in funding guarantees outstanding! Total shareholder equity at Bank of America is around $150 billion. So... the bank risked two-thirds of its equity to earn relatively small fees by providing funding guarantees to SIVs. That seems incredibly risky... and stupid. The amount of capital it has been forced to provide SIVs has grown from less than $200 million to $6.6 billion by the end of 2007. The quarterly press release makes no specific mention about these obligations. However, a sizeable discrepancy exists between the bank's net charge-offs and its total managed losses, which would include losses from its SIV guarantees. Managed losses totaled $5.2 billion, about $2 billion more than its net charge-offs.

Given that Bank of America isn't saying anything about its commitments to SIVs, how could any reasonable investor buy the stock? The fact is, an outside investor has no way to know what equity in Bank of America is worth. It could easily be worth a lot more than $30... but it could also easily be worth nothing. Given the risks of LaSalle's mortgage book, Countrywide's mortgage book, and the $100 billion in SIV funding guarantees... I find it pretty incredible Bank of America's CEO is still insisting the bank won't cut its dividend and won't have to raise more capital. I'm sure he's wrong.

If you haven't seen the dancing Filipino prisoners yet, take a break from worrying about your stocks and our country's banks. This is amazing stuff.

I hate being in the crowd when it comes to the stock market. And the short side of the market is very, very crowded. More than $1.4 trillion of worldwide equities, approximately 2.8%, is on loan... about one-third higher than at the start of 2007. And most of that is going to short sellers. Short selling on the New York Stock Exchange rose to 4.6% last month, the highest since at least 1931. It seems inevitable we're going to have a big rally, just to shake out the weak hands from the short side.

Morgan Stanley and Dresdner Kleinwort have until 4:30 p.m. tomorrow to sell $7.6 billion of HBOS stock. The two brokers are trying to dump 1.38 billion shares of the U.K.'s biggest mortgage lender after investors bought 124 million shares, only 8% of the offered shares. The HBOS rejection was the biggest shareholder rejection of a European offer this decade. This is exactly what would have happened with last Monday's Fannie and Freddie auctions had the government not stepped in.

One man who's happy about the failed HBOS rights offer... Phil Falcone of hedge fund Harbinger Capital. Falcone disclosed a 3.29% short position, $665 million, in HBOS on June 20. Shares are down 62.7% this year, and 6.2% today. Harbinger Capital's main fund is up 42% so far this year.

Another hedge-fund guru, Seth Klarman of Baupost Group, recently bought 23.2% of RHI Entertainment (RHIE). RHIE produces and distributes made-for-TV movies, miniseries, and other television programming worldwide. It also holds the rights to approximately 1,000 existing titles.

And one more stock for you to consider, courtesy of the world-class value investors at Tweedy, Browne. "We have established a position in Swiss Re, the world's largest reinsurance company. The company at initial purchase was trading at 5 times earnings, 77% of book value, 70% of imbedded value and a 6% dividend yield. Earlier this year, Warren Buffett purchased a 3% position in the company, and has agreed to take on 20% of Swiss Re's property and casualty business over the next 5 years freeing up reserves for a stock buyback."

A lesson for people who don't know how paper money "works." Zimbabwe's troubled central bank introduced $100 billion banknotes Saturday in a desperate bid to ease the recurrent cash shortages plaguing their inflation-ravaged economy. The bills officially come into circulation Monday, although they were on the foreign currency market Saturday. As high as they are, though, the bills still aren't enough to buy a loaf of bread. They can buy only four oranges. The new note is equal to just one U.S. dollar.

Barrick Gold, the world's largest gold company, expects a considerably higher gold price within the next five to seven years... a surprising announcement, considering Barrick's generally conservative price estimates. CFO Jamie Sokalsky expects mining output to decline 10%-15% over the next five years. All other major producers agree. Pierre Lassonde, the former president of Newmont Mining, the second-largest gold company, pointed out there have not been any major discoveries of more than 30 million ounces in many years, which is why he also expects a drop-off in production.

Speaking of higher prices... I have a good contact in the homebuilding industry – a very senior manager, a guy who has been in the business for 15 years. He told me last week that all of his suppliers are trying to push 15%-20% price increases across the board for everything. There's no way the homebuilders can pass these costs along to homebuyers – the housing market is way too fragile. This will be the final nail in several national homebuilders' coffins.

New highs: Baxter International (BAX), Barr Pharmaceuticals (BRL), Heartland Express (HTLD).

In the mailbag... We've got it all wrong on Fannie and Freddie, says a mortgage industry insider. We'll let you decide, dear subscriber. Send your comments here: feedback@stansberryresearch.com.

"You have truly descended into irresponsibility with your comments on FNMA/FHLMC. You reveal a frightening ignorance of how they work. In recent columns, you compare them to Wells Fargo and to Countrywide. Both comparisons are apples-to-oranges. The US real estate market has been devastated by heavy foreclosures... The extraordinary default rate has now affected values to such a level that there will be some resultant defaults even with the conservative FNMA/FHLMC loans. However, the risk on FNMA/FHLMC loans is vastly lower than for the risky loans promoted by irresponsible lenders, such as Washington Mutual and Countrywide, both of which should be allowed to fail. Please exercise the self-discipline to restrict your comments to areas where you have useful knowledge. (I love the GM Chairman letters.) But your ignorant comments here are only making a tragic situation worse. Of course, if your goal is to destroy the US financial system, then I suppose your comments serve a purpose by vastly exaggerating the risk and furthering a panic. I offer no opinion about FNMA/FHLMC management, only that their portfolios are far less at risk than you claim." – Paid-up subscriber Bill Matz

Porter comment: Bill is correct regarding the loans that Fannie and Freddie guarantee – they're conservative. But he's dead wrong in regards to the portfolios they own. Freddie and Fannie hold something around $500 billion worth of subprime and Alt-A mortgages, nearly all of which were underwritten during 2005, 2006, and 2007. These loans have serious problems and losses from them could easily bankrupt the firms. Additionally, a slowing economy, a hugely indebted U.S. consumer, and falling real estate prices should all combine to undermine the value of even a conservative mortgage portfolio. Considering Fannie and Freddie own or guarantee about half of the mortgages in America, they will inevitably take losses at least similar to other large financial institutions. To believe otherwise is to believe in Lake Wobegon, where all the kids are above average.

"F*&# Skousen, he's up to his neck with the scumbags who run this sideshow. So when are you going to post either the audio of your speech or the video itself? We all await your 'Doug Stanhope' moment (you do know who he is, right? If not, check him out on Showtime. Or pick up his NO REFUNDS video. He's the guy wearing the baseball shirt with 'libertarian' scripted across it)." – Paid-up subscriber Mike McCormick

Porter comment: I'm sorry... I have no information about where you could purchase a recording of my speech. Try looking on the FreedomFest website. But I promise to give it again at this year's Alliance meeting in Hong Kong.

"Your recent Digests have been excellent. Spot on. I'm furious at the likes of Pelosi, Harry Reid (a complete fool), Frank, Levin (Michigan), Chris Dodd, California democrats, the entire Bush administration, and the Congress (both sides). Blaming speculators for the run up in oil prices?? Give me a break. Trillion dollar annual deficits on the way. $15 [trillion]-$20 trillion national debt. Deficits don't matter (remember that one?). More taxes on the wealthy and small business, like California is about to do. And how do you calculate core inflation excluding food and energy prices?!? Unfortunately I like many Americans are frustrated because there is little we can do about this massive collection of idiots, at least in the short run. I hope your emails of the Digest are reaching their in-boxes." – Paid-up subscriber Ron Martin

Regards,

Porter Stansberry

Baltimore, Maryland

July 21, 2008

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