The Failure of Fannie and Freddie Is Only the Beginning

Time to learn a new shtick... In the dark for hours this morning... What to do now... Mike Williams on GM bonds... Move to France you liberal "pansy"... Dan's No. 1 idea...

I'm going to have to learn a new shtick... For the last few years, I've used the "tell 'em it's going to zero" shock line. Never mind that anyone looking honestly at the numbers would have reached the same conclusion – nobody believed me. And I'm sure very few people believed Dan Ferris when he predicted Lehman's impending doom. But lots of folks wanted to know why we thought these well-known businesses would soon go bankrupt. No one else was publishing that kind of information. Now, you can hear the same message on CNN. And that means it's time to focus on the stocks that aren't going to go bankrupt no matter how much worse this financial crisis becomes.

Despite being pretty plugged into the situation on Wall Street, I must admit I was shocked this morning to see two of Wall Street's biggest names disappear in a single day. In fact, when I first saw the news – via an e-mail on my Blackberry from Dan Ferris – I thought he was making a prediction, not reporting the facts. It was very early this morning – about 3 a.m. I'd gotten up early to drive down to Hatteras, North Carolina, with my family. For the next four hours, I drove south in the dark, silently wondering...

What should you do? Dan has his own ideas (which he shares below), and I have mine. I believe, as I've said for some time, we're witnessing the end of the dollar standard. Paper money doesn't work. It always leads to excess. In all of human history, every single experiment with paper has collapsed. Will the end of the dollar be deflationary (like in the Great Depression) or inflationary (like Weimar Germany's great hyperinflation)? I don't know. But my bet, especially since the Fed took over Fannie and Freddie, is an inflationary spiral. And as people lose confidence in the dollar, our government, and their banks, they will turn to gold and silver.

Other assets also do well during periods of rising inflation – namely capital-efficient common stocks. You'll find a list of ultra-high-quality, capital-efficient common stocks in the current issue of my newsletter, PSIA. So in addition to owning gold and silver bullion, I'd recommend you buy a few of the world's greatest corporations while they're on sale.

Finally, just because things are going badly on Wall Street and for our government, there's no reason why things have to go badly for you. We've been recommending selling stocks short, which allows you to make a profit as their price falls. We've made a few huge gains this way – most recently in Lehman Brothers. I wrote up my latest short-selling idea last week in my newsletter. In this case, it's not just one company that's going to zero; it's an entire industry.

I asked our bond expert, Mike Williams, editor of True Income, to comment on Mason Hawkins' (of Southeastern Asset Management) switch from GM common stock to GM bonds. Says Mike:

Southeastern used to have a great reputation as a deep value player. The move into GM bonds smacks of desperation. I wonder how much he lost on the sale of the GM common. I am not sure the convertible bonds give him a better position in bankruptcy. The legacy costs, especially the pension and retiree benefits, will accelerate and vest in a bankruptcy, and may stand in front of him. If these pension liabilities get assumed by the federal Pension Benefit Guaranty Corp., it will be extremely aggressive in asserting its rights. I am not sure Southeastern is going to be much better off than owning the common... The thing is bankrupt and they just don't know it yet. Better to not own any of it until it starts to smell bad. Then there may be opportunities.

New high: Biomed Realty Trust (BMR).

In the mailbag... The liberals reply: "Porter is definitely not one of us." No, I'm certainly not. Send your comments here: feedback@stansberryresearch.com.

"Stick to giving investment advice. You are painfully and embarrassingly ignorant about political matters and poking your ass into that hornet's nest has probably cost you more than a few cancellations of subscriptions. Anyone who favors the coddling of captured terrorists and opposes the wiretapping of incoming communications from identified terrorists should show just a slight degree of common sense and not espouse those views publicly on or about September 11th, if at all. You are a disgrace and I wish your customer service staff would stop sending your garbage to my email address as I requested after reading your misguided anti-American diatribe. Move to France you liberal pansy." – Anonymous

"I find it hard to imagine someone thinks ANYONE at S&A is liberal. Believe me, I'm a liberal and Porter ain't one of us." – Paid-up subscriber DK Smith

"Lazzarino confuses liberal with libertarian. It upsets me that people like that are allowed own scissors (much less vote.) On second thought, let Darwin have his way." – Paid-up subscriber RD

"I am 57 and am also a registered Republican and have voted Republican for 30 years. I can tell you I am disgusted with what passes for a 'conservative' today. We are really in trouble when somebody like Ron Paul (a true conservative) is booed and lambasted at the debates by other Republicans when all he is saying is what the FOUNDERS of this country said over and over again! What parades around today as patriotism is NATIONALISM at its best. A neocon is just another liberal. There is nothing displaced about Porter's patriotism... I am sure we could debate the privileged life he (Porter) has or hasn't had it's irrelevant for the subject at hand and, for that matter, my life is hardly one of privilege since I have been in the roofing business for the better part of 40 years (yes, extremely hot hard work)." – Paid-up subscriber Gary Carruth

"Someone has to write back to offset these crazy hyper-conservative Neo-Cons. You ABSOLUTELY nailed it on the head when you noted that loving your country is entirely different than loving your government. I 100% agree. People need to remember that the constitution was not written to grant Americans rights, but rather to chain government to a set of rules and principles to keep them from trampling our rights. Further, the USA is great not because of the government, but rather IN SPITE of the government. Recent presidential regimes have served only to grab more power and infringe the rights of the people at every turn. They've run up taxes & spending, destroyed our good name, and ruined much of what was good in this country. Fighting terrorism never has been and never will be a valid reason for abridging our constitutional rights. Finally, if it was Muslim extremists that caused 9/11, then why is every American citizen now treated as a potential terrorist? Hmmmm... In conclusion, keep on telling it like it is, Porter! We need more people to stand up for the principles that made this country great." – Paid-up subscriber Michael Morning

"What gives with the 'cheap shot' about 'doctors, dentists, and lawyers?' Where did you get information that only 'under Bush' did this group see there after-tax income increase? Take your foot out of your mouth and prove it. I dare you. Are you just jealous that you don't have a 'professional degree?' Well, they don't give them away – if someone has gotten one, they got it the old fashioned way – they had to 'earn it!' What have you done to get your knowledge? Does 'professional degrees' also include PHDs? Dr Steve Sjuggerud got his the old fashioned way also – he earned it!I think if you are going to make a statement – then give some information to back it up! Your 'running off' at the mouth is getting tiresome! One who EARNED his degree!" – Paid-up subscriber D. Cook

Porter comment: The United States is one of the few places in the world where you need a doctor's permission to buy useful and safe drugs. Why? The American health care system is the most expensive in the world – by a huge margin – but offers only mediocre results, measured in terms of life expectancy. Why? These are obvious signs of a union at work. Lots of controls. High prices. Poor results.

I have no problem with advanced degrees. Many of my friends are doctors or have Ph.Ds. They're no more or less stupid than anyone else I know. My problem isn't with doctors. I object to the government-like role their unions have acquired in our society whereby they have the power to determine what I am or am not allowed to do with my own body.

"If Goldman Sachs accounting is so suspicious (and I agree) then why don't we short these crooks?" – Paid-up subscriber I.M.

Porter comment: No reason I can think of.

Regards,

Porter Stansberry

Hatteras, North Carolina

September 15, 2008

The Failure of Fannie and Freddie Is Only the Beginning

By Dan Ferris

"Screw the currency, screw the taxpayer, and keep the whole thing propped up."

If you're not fluent in Treasury-speak, you might not have picked this up from the documents detailing the Fannie Mae/Freddie Mac bailout. But after spending a lot of time studying the biggest financial disaster of our generation, I know that's what they say.

The bailout involves three primary agreements.

One of them is an agreement by the Treasury to acquire new senior preferred stock amounting to 79.9% of equity. The old shareholders now own just one-fifth of the equity, and the new preferred shares are senior to all the old preferred shares. In other words, the American taxpayers are Fannie and Freddie's new controlling shareholders.

Another agreement describes the Treasury program to buy Fannie and Freddie's mortgage-backed securities in the open market, $5 billion worth, initially. This is a government subsidy to homebuyers, keeping interest rates low and failing to discourage risky behavior on the part of borrowers and lenders.

A third agreement details a new Treasury credit facility that will make cheap 30-day loans to "government-sponsored enterprises" (GSEs): Fannie, Freddie, and the Federal Home Loan Banks. The GSEs will pay a paltry 50 basis points (0.5%) above LIBOR, which is what the most creditworthy institutions pay. These cheap loans represent another taxpayer subsidy to the financial system and more incentive to take on too much risk.

There's some very important language for investors in these agreements.

From the preferred stock purchase:

These agreements are the most effective means of averting systemic risk and contain terms and conditions to protect the taxpayer.

From the mortgage-backed security purchase:

Treasury is committed to protecting taxpayers and will ensure that measures are in place to reduce the potential for investment loss.

And then there is the much ballyhooed implied government guarantee of the GSEs, made explicit by the U.S. Treasury:

To address our responsibility to support GSE debt and mortgage backed securities holders, Treasury entered into a Senior Preferred Stock Purchase Agreement with each GSE which ensures that each enterprise maintains a positive net worth.

Allow me to translate the above passages...

Protecting the taxpayer against investment loss and ensuring the GSEs maintain a positive net worth means printing enough money to back nearly $6 trillion of mortgages and mortgage-backed securities owned and guaranteed by Fannie and Freddie. It means the Treasury doesn't care if it has to drop money out of helicopters to keep the charade going.

It boils down to what I said a moment ago, "Screw the currency, screw the taxpayer, and keep the whole thing propped up."

But the Treasury's new commitment totals just $200 billion, less than 4% of the GSEs' total held and guaranteed mortgages. That doesn't seem like it could possibly be enough to absorb the coming losses.

I said I expected at least $1 trillion of mortgage losses back in April. That figure may prove too low. Too many loans were made with substandard underwriting parameters like low FICO scores, inadequate income documentation, and little or no down payment.

I can imagine total losses of 10% (roughly $1.2 trillion or higher). If I'm right about this, both GSEs will require substantial new capital injections of many times the initial $200 billion commitment.

Where does all this backstop money come from? Taxes, but there aren't enough taxes to pay the government's budget now. So it just creates what it doesn't have by selling new debt. That's what our money is: monetized Treasury debt.

It's as if you decided you wanted another $1,000 in your checking account, merely added that amount to your balance, and started writing checks against it... checks the bank honored. Lately, the Federal Reserve, which is a private corporation granted extraordinary powers by law, has been adding lots of numbers to its checkbook.

Federal Reserve bank credit grew at an annualized rate of 9.5% the last three months, more than two and a half times the rate of the last 12 months (3.7%).

Foreign central banks create money and buy Treasuries, too. From August 2007 to August 2008, foreign central bank holdings of U.S. Treasuries surged 21%, from $1.98 trillion to $2.40 trillion. Foreign central bank holdings of Treasuries grew at an annualized rate of 23.6% the last three months, versus 19.6% over the last 12 months. There's plenty of new credit out there all of a sudden. New credit is new money. This is the definition of inflation.

That's why I said at the outset that the failure of Fannie and Freddie is only the beginning. Fannie Mae, Freddie Mac, the Federal Home Loan Banks, the FDIC, Social Security, and the Pension Benefit Guaranty Corporation all force the U.S. taxpayer to subsidize the government-led underpricing of risk.

Inadequate risk compensation and taxpayer guarantees, explicit or otherwise, attract the wrong managers. Those managers then push the system to its limits, taking on more underpriced risk... which requires more backstopping... all of it requiring new money.

That's why Fannie and Freddie failed. That's why those other government schemes will fail. And that's why the U.S. dollar is doomed. Don't mind the short-term rallies. The dollar is burnt toast.

Good investing,

Dan

Porter comment: One more thing... Dan says one stock in particular is going to make investors big, safe profits over the next several years, thanks to this crisis. It's his new No. 1 pick. (His last No. 1 pick, Wal-Mart, is up 43% over the last 12 months.)

Extreme Value readers should check his latest issue for details. If you're not a subscriber, you should be. Click here to get a risk-free preview.

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