The S&A Digest

Editor's note: While our track record didn't escape the general market rout this year, we did make several profitable short-sell recommendations. Dan Ferris called the failure of Lehman. Porter nailed Fannie Mae, Freddie Mac, and, of course, GM. Check the highlights, below...

We wrote it, did you short it?

I suspect that if it were more transparent in its reporting and more honest about the fair values, it would have reported much larger writedowns. As of its latest balance sheet, Lehman Brothers reported $786 billion of assets and $21.8 billion of equity. I expect a wipeout of anywhere between 20% and 50% of Lehman's equity over the next 12 months. One way or another, the $4 billion Lehman raised this month will prove to be far less than adequate. – Dan Ferris, Extreme Value, April 2008

The front page of today's Wall Street Journal reads, "Losses Push Lehman To Weigh Raising New Capital." On June 16 Lehman (LEH) will likely announce a $300 million loss, its first quarterly loss since going public. The company needs to raise $3 billion to $4 billion to fortify its balance sheet. Shares are down about 9% today.

Lehman Brothers is Dan's first ever short sale in Extreme Value, and it's a blockbuster. His readers are up 23% on the recommendation, and Dan thinks more losses are on the way for Lehman. – Porter, June 3, 2008. (Lehman declared bankruptcy on September 15.)

Financially speaking, it might be the end of the world...

Shares of Fannie Mae and Freddie Mac plunged today. At one point, around noon, the stocks were simply in freefall. The collapse happened right after bond traders began marking down the "agency" bonds of both companies. These are packages of mortgage securities guaranteed by Fannie or Freddie.

The spread between agency debt and U.S. Treasuries reached a 22-year high today, which indicates bond traders no longer have confidence in Fannie's or Freddie's ability to guarantee their mortgage securities. If the agency bonds continue to trade lower, it will spark chaos in the financial markets – a kind of global run on the bank. Most U.S. banks hold agency debt as their reserves. Banks would have to sell agency debt (at a loss) and buy U.S. Treasury bonds or else risk falling under the standards for capital reserves.

This is exactly the kind of crisis I warned my subscribers about in my last newsletter:

...most people don't realize how important the U.S. mortgage market has become to global liquidity. Ten years ago, the total U.S. mortgage market was about $3.5 trillion, roughly equal to the U.S. Treasury market. Today, the U.S. Treasury market has grown to $4.5 trillion. But the U.S. mortgage market has more than doubled to about $9.5 trillion.

These mortgages, packaged into securities guaranteed by Fannie Mae and Freddie Mac, make up the reserves of financial institutions all over the world. As these securities fall in price, they're reducing the amount of available outstanding credit globally on a leveraged basis. – PSIA, June 2008

What should you do? Ideally, if you've been reading my letter, you're already short

several of these hemorrhaging financial stocks (not to mention GM), so you're well-protected. – Porter, July 7, 2008. (Fannie Mae and Freddie Mac went into conservatorship on September 7. Their stocks, which still trade on the NYSE, have lost more than 98% of their value this year.)

You can't say we didn't warn you...

In his last "Letter from the Chairman," on August 6, 2008, Porter wrote:

GM is now in a death spiral. In the most recent quarter, we lost more than $15 billion. Our sales volume fell 20% from last year. We even lost $2.4 billion on leases – which indicates bigger problems to come. We're no longer offering leases on most of our cars, a move that will decrease revenues further. About 10% of our sales volume comes from leases. We are now down to $21 billion in cash. As I've told you, we must have between $10 billion and $14 billion to keep operating. Given the rapid decline of our operations and revenue, I think we'll be very lucky to survive 2008. There's no way we can last through the end of 2009 without filing for bankruptcy.

From today's Wall Street Journal:

October's declines were led by GM, whose sales fell 45% to 168,719 vehicles. The company was hurt when its financing arm, GMAC LLC, began offering loans only to customers with top credit scores. In many areas of the country only a third or so of all customers would qualify for loans, Mr. DiGiovanni said. GM padded its sales total with sales to fleet customers like rental companies. Fleet sales made up a third of its total, meaning its "retail" sales to individual consumers totaled only about 113,000 vehicles... "In my 27 years, I have never seen a month like this," said GM's sales chief Mark LaNeve. "It was like somebody turned off the lights in the month of October."

According to Michael DiGiovanni, GM's executive director of global market and industry analysis, if the carmaker's sales were adjusted for population growth, October would be the worst month of the post World War II era. – Dan, November 4, 2008. (You can read Porter's first "Letter from the Chairman" here. GM is down 88% this year, trading at an all-time low.)

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. – Dan, September 16, 2008. (Read the rest of Dan's essay Next Up in the Dead Pool for his call on National City and Wachovia. Both companies were "saved" by acquisition deals. Their stocks are down more than 50% since Dan covered them in The Digest.)

This doesn't sound good...

We're not running our company on a month-to-month basis. We're running our company on a more intermediate to long-term basis, so I think that we look at the trends, we'll provide you with good information every quarter, and that will hopefully be ample for all of you to understand the direction that the business is [moving].

That's the explanation Gracia Martore gave analysts during his company's earnings call today for ceasing monthly revenue reports. Martore is the CFO of America's largest newspaper holding company, Gannett. Gannett's revenues fell 18%... and now, suddenly, no one wants to talk about revenues each month. Yes, Gracia, we can all understand the direction the business is going in. And that's why we've recommended selling short your company's stock. – Porter, October 24, 2008. (PSIA subscribers made 56% on Porter's recommendation to short Gannett.)