The S&A Digest: A Gun-Shy FDA is Our Best Friend

A foreclosure tsunami... JPM vs. BLX... Buffett on the crisis and CDOs... More losses at Merrill Lynch... Cerberus founder speaks... BlackRock bullish on Russia, Brazil... More controversy: heroin and trailing stops... When the FDA is our friend...

JPMorgan Chase's investment-banking business took $2.6 billion of writedowns to leveraged loans, prime mortgages, alt-A mortgages, and subprime mortgages. It was also hit by rising delinquencies, requiring another $1.1 billion loss reserve on its $95 billion portfolio of home-equity loans. With home prices still way too high, count on more of this.

The second-largest bank by market cap then told the world its prime-mortgage portfolio had experienced higher charge-offs than expected. JPMorgan Chase said its Tier 1 capital remains "strong at 8.3%." You can think of "Tier 1 capital" as the buffer a bank has to absorb losses. American banks are thought to be well-capitalized at a 6% Tier 1 ratio.

Extreme Value pick Bladex (BLX) has nearly two and half times that much Tier 1 capital. It cut its Tier 1 capital in half by paying out special extra dividends over the last few years, and it still has excess capital. Nothing like what's happening with Wall Street, where everyone is selling new equity.

My humble opinion is that a tsunami of foreclosures and defaults is coming. In the current issue of Extreme Value, I told readers to keep their eyes on the approximately $17 trillion of outstanding prime residential mortgages, alt-A, B & C (subprime), home-equity lines of credit, consumer credit, and commercial real estate loans. The lending standards on all types of loans fell off a cliff in 2005-2006. Since it takes, on average, around 15 months for a mortgage to go bad, it all started to hit with a vengeance in late 2007. And it's got a long way to go because most of these assets sit on highly leveraged balance sheets. When the writedowns come, capital disappears like a paycheck in a strip club.

In a new Fortune article, Warren Buffett expressed a view much like that expressed in the current issue of Extreme Value. Buffett said the credit crisis will go on for a long time, saying, "I mean, it seems everybody says it'll be short and shallow, but it looks like it's just the opposite. You know, deleveraging by its nature takes a lot of time, a lot of pain. And the consequences kind of roll through in different ways. Now, I don't invest a dime based on macro forecasts, so I don't think people should sell stocks because of that. I also don't think they should buy stocks because of that."

Buffett also gave the clearest explanation yet of how hopeless it is to understand a CDO, and how lousy these instruments are at reducing risk. He's looked at prospectuses, and it's absurd to think anyone could adequately study 15,000 pages of material, or 750,000 pages for a CDO squared. He also noted so-called super-senior securities, i.e., the top 50% or so of CDOs, aren't super-senior or senior at all. Says Buffett, "It isn't super-senior or anything. It's a bunch of juniors all put together. And the juniors all correlate." In other words, the purported reasons for the existence of CDOs are bogus. The real reason comes into bolder relief: CDOs were created to feed the Wall Street fee machine.

It's nice to have Buffett agree with me. But lots of folks are jumping on the it's-going-to-get-a-lot-worse bandwagon. A week or so ago, the IMF estimated mortgage losses would total close to $1 trillion. The latest new voice on the subject is Frank Veneroso's. I used to try to read Veneroso's gold-price forecasts several years ago, but I couldn't make heads or tails out of them. Veneroso, who works for Allianz, is the most wildly pessimistic I've heard yet.

Defaults of $3 trillion out of a default prone aggregate of $7 trillion seems realistic to me. That brings with it $1.8 trillion in dead weight losses. To this we might add almost $300 billion plus or so of business defaults and more than $150 billion of dead weight credit losses over time. The business losses bring the total into the $2 trillion range.

"Two trillion dollars of losses" has the ring of "Dow 36,000," doesn't it? I'm not really sure what a number that size means, but it sounds bad. And sounding bad makes headlines. The reason all the loss estimates are getting higher and higher is leverage. When $1 of capital supports $10 of assets, then a $500 billion loss suddenly puts $5 trillion of assets in limbo. This basic arithmetic prompted me to make my very first short sell recommendation since I started writing Extreme Value in 2002.

And one day, when everyone agrees the end of the world is nigh, hopefully, we'll be telling you to buy Merrill Lynch, speaking of which...

Merrill Lynch posted its third-straight quarterly loss and will cut about 4,000 jobs after at least $9 billion of writedowns and a 40% drop in investment-banking fees.

Merrill Lynch lost $1.96 billion in the first quarter, versus earnings of $2.16 billion in the first quarter last year. Merrill's new CEO, John Thain, spent his first four months as chief executive officer selling more than $12 billion of equity to bolster capital and overhauling risk-management practices after more than $20 billion of credit-market losses. Merrill's stock is down 50% the past 12 months.

Backlash is an inevitable part of any bursting bubble, and the leverage bubble is no different. Private-equity mogul Henry Kravis is the target in this video, which seems to indicate private equity is responsible for unemployment and the poor quality of roads and hospitals in some communities. Naturally, the connection is never made clear with actual facts or reasoning. I hate our loophole-ridden tax system. But I'm not sure the answer is to soak the rich. The answer is to have less government and tax everyone at the same rate. It's incredible to me that grown adults ever come to any other conclusion.

As though he'd seen the video above, Stephen Feinberg, the reclusive founder of private-equity firm Cerberus Capital Management, told an interviewer recently, "It's important for American manufacturing not to disappear. It has been a dream to have the opportunity to build these American companies..."

These "American companies" Feinberg is talking about are Chrysler and GMAC, which Cerberus owns. Feinberg says, "We have a national responsibility. We can't let ourselves fail."

Chang Lin-yun, managing director of investment manager BlackRock (Taiwan) Ltd, told Reuters, "We are buying shares of Russia and Brazil, as global supplies of energy and commodities remain very tight. Prices of these products have been strong for the last five years. We don't think this trend will change its course anytime soon."

Long term, I agree. But a few weeks ago, I went to a conference full of mining-stock investors. They were positively smug in their bullishness on gold, copper, and just about anything else you can dig out of the ground. Again, I agree with them long term... but when making money looks easy – especially in gold – it's the time to get cautious.

Most people are momentum players at heart. When they get "confirmation" of the trend, the well-informed value players are beginning to lighten up and take profits. For example, I'd expect to see gold at $750 before it hits $1,750, though I view the latter as absolutely inevitable.

In today's FDA Report essay, our last in the series, Dr. Huang explains why an overzealous FDA will keep his trading strategy profitable for many years. Yesterday, Dr. Huang showed subscribers how to buy a penny biotech stock with 10 drugs in the pipeline for only $25 million. He expects this stock to double within 12 months. To learn more about the S&A FDA Report, click here...

New highs: EnCana (ECA), Comstock Resources (CRK), Sabine Royalty Trust (SBR), XTO Energy (XTO), Transocean (RIG), Plains Exploration (PXP), Valhi (VHI).

To share your views on Afghani poppy fields, trailing stops, or any other important topic, be sure to write us at feedback@stansberryresearch.com.

"In my 35 years plus of working in heavy industry, I have discovered that the best way to confirm a rumor is to have management deny it. If Lehman and Goldman are calling a 'bottom,' you can rest assured that the worst is yet to come." – Paid-up subscriber Mark

"Mr. Clark can sure call the market. Bought his recommendation of SMH calls during lunch on Tuesday and had doubled my money by lunch on Wednesday! Thank you, Mr. Clark! I hope you never leave the S&A family as I plan to follow your work for many years to come!" – Paid-up subscriber Tim Eveslage

Goldsmith comment: Two days ago, Jeff Clark told S&A Short Report readers, "Semiconductor stocks are ready to make a major move one way or another. And the catalyst will likely be Intel's earnings report. I'm betting on an upside surprise." The calls he recommended were up 100% the next day. Click here to learn how he does it.

"Re: The heroin in Afghanistan. It's too dangerous to go in and eradicate the fields? I cannot see why several quick bombing runs wouldn't work. Can our intrepid soldiers not accomplish that with little problem? Of course, I'm not in or associated with the military so I am not well informed, but surely they can use our superior equipment to eradicate the fields." – Paid-up subscriber Marilyn Tuppen

Ferris comment: Aside from just being wrong, bombing poppy fields in Afghanistan is the sort of thing that makes people want to crash airplanes into tall buildings in Manhattan. Walter Block writes in his book, Defending the Undefendable, "The evils commonly blamed on heroin addiction are in reality the fault of the prohibition on drugs and not of the addiction itself. Given the prohibition on drugs, it is the person who sells drugs illegally who does more than anyone to mitigate the evil effects of the original prohibition."

Prohibition simply raises the price, creating a huge incentive, attracting murderers to the business, and pushing out honest businessmen. I can't believe an adult alive anywhere doesn't get this by now.

"When I fired the big bull broker and took over my portfolio, this neophyte dutifully 'protected' stocks with GTC stop losses just as the how-to-trade books said to do. After the loss of two or three stocks to market makers swooping in the day before ex-dividend for a quick and profitable snatch-and-run, this great-grandma told herself, 'Girl, that's not the way to do it. Keep it to yourself.' No more 'stolen' dividends. Last year, I asked TDAmeritrade (I had switched brokers) how on-line-entered sell limits were handled and was told that the sell limit order would not be placed until the stock price dropped to the limit price and then the sell order would be sent to market. The young man volunteered that TDA's policy would protect me from the vultures (his word). Thanks TDA." – Paid-up subscriber Great-grandma B

Regards,

Dan Ferris

Medford, Oregon

April 17, 2008

A Gun-Shy FDA is Our Best Friend

By Dr. George Huang, editor, The S&A FDA Report

Every good trading strategy flourishes for a period before the market catches on and the traders pile in, squeezing out the outsized profits.

Right now, as I'll explain, a set of unique circumstances is making it possible for us to make a killing in The S&A FDA Report... for at least the next three years.

The Vioxx debacle of 2004 (when Merck withdrew the popular arthritis and pain-relief drug because it increased the rate of heart attack and stroke) represented a turning point for the FDA...

To be blunt, ever since Vioxx hit the headlines, the FDA has become so much worse than hesitant or extra cautious... It's downright spineless. Instead of being an advocate of society's health, it's become a detriment to millions of Americans waiting and hoping for new and improved drugs.

Not only does the FDA want to avoid being caught in the headlines for being "soft" on safety, it also doesn't want to give the appearance of being in bed with the drug industry. So the FDA continues to require drug companies to conduct more, larger, and more expensive clinical trials. And it's approving fewer and fewer drugs each year...

In 2007, the FDA approved only 19 truly new drugs, the lowest total since 1983.

The FDA approved an average of 28 truly new drugs a year from 1999-2004. After Vioxx, the average number of approvals dropped to 20, a decline of 30%.

Historically, the FDA approves about 80% of new drug applications (NDAs). However, according to Sagient Research (an independent research firm for institutional investors), the FDA's drug-approval rate has decreased from 73% in 2006 to just 64% last year. The remaining percentage of decisions were "negative responses" (including both approvable and nonapprovable letters), a 10% absolute increase compared to 2006.

In the next three to five years, I expect the percentage of FDA approvals for NDAs to hover around 60%-65%, providing us with a large number of trading opportunities. I expect the FDA to issue about 60 overall decisions in 2008, 20 of which should be "negative." From this pool of trading opportunities, we'll have plenty of good stocks that fit within our four-pronged test for no-brainer trades (you can read about our four criteria here, here, here, and here)...

On top of the "favorable" regulatory environment, our trading strategy depends on subscribers being small and nimble. Most of the eligible FDA Report stocks will be in the $100 million-$500 million market-cap range. Smaller stocks are generally too tiny for most trading institutions to take advantage of. And mutual funds and hedge funds typically cannot build large enough positions (without driving up stock prices) to make such trades worthwhile. Thus, FDA Report subscribers will have plenty of time and space to make the trades we recommend.

Finally, the market's current need to be in cash, bonds, and all things "safe" will continue to drive down biotech stock prices to levels last seen in 2002, after the tech bubble burst. To get a feel for what I expect our returns to be this year... the Nasdaq Biotech Index returned 45% in 2003.

In short, in today's climate, we'll have plenty of chances to trade with very little downside... and hundreds of percent of upside potential. In 2008, I expect the FDA to provide roughly 20-25 trading opportunities, with eight to 10 fitting our trading criteria.

Good investing,

George Huang

P.S. Using the FDA Report system, you can pinpoint potentially lucrative trades - months in advance. Right now, I'm monitoring a trade I think could generate a minimum of 75% gains in the next year. Click here to find out more.

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