The S&A Digest: A New Opportunity to Front-Run the Chinese

A new opportunity to front-run the Chinese... It's over... Gettelfinger didn't get the memo... Insiders buying financials... Merrill's bag holders... Buffett on estate taxes... A Digest hiatus...

The End of the Great Credit Bubble

And so it ends...

Shares of Freddie Mac fell nearly 30% today as the government-chartered mortgage bank marked down the value of the mortgages it holds by $3.6 billion and reported a $2 billion loss for the quarter. The news from Freddie follows a similar $1.4 billion loss at its larger government-chartered sibling, Fannie Mae.

Every investment mania has a primary source of funds – "liquidity" as it's called in certain circles. In the great real estate/debt boom of 2001-2006, the two government-chartered mortgage banks served as the primary sources of liquidity. In fact, the terms under which Freddie and Fannie offered financing and mortgage guarantees were so absurdly generous that an entire secondary industry was born – so-called mortgage REITs. (We've recommended one of these companies, Annaly, several times.)

Today, Freddie and Fannie own or guarantee a combined $4.8 trillion worth of mortgages – by far the largest pool of mortgage assets in the world. These quasi-government businesses control these assets by using a truly stupendous amount of leverage. Fannie, for example, owns or guarantees $2.8 trillion worth of mortgages with a $40 billion capital base. Freddie is responsible for another $2 trillion worth of mortgages with a capital base of only $34.6 billion. Doing some basic math shows a 1.5% decrease in the value of their combined mortgage books would wipe out shareholders at both companies... leaving taxpayers to clean up the mess.

Clearly, the flood of money created by Freddie and Fannie – in conjunction with the U.S. Federal Reserve – inflated the value of their mortgages. Additionally, fraud likely played its part. New York Attorney General Andrew Cuomo has launched a probe in the lending practices of banks that sold mortgages to Fannie and Freddie. I have no doubt he'll find what he's looking for... In Miami, there are entire buildings of condos where a majority of the units were sold to fraudulent buyers. Although my estimate is only a rough guess, I'd bet the real value of Freddie and Fannie's mortgage book is overvalued by at least 10%, which would cause a $280 billion loss.

And here's the kicker... Both Fannie and Freddie still hold a AAA credit rating because of the implied U.S. government backing. And whom will the government end up paying off? Foreign investors hold more than $1.2 trillion of Fannie and Freddie's bonds, with China owning the biggest share.

Bye, Bye General Motors. Yesterday, the shares fell 8.5% on the day... and they're down considerably since the "chairman's" most recent warning. What's the problem now? Mortgages. Last year, you'll recall that GM sold 51% of GMAC to Cerberus Capital Management, a Wall Street private-equity firm. As part of the deal, GM had to guarantee GMAC's book value. That book value has already been written down twice... and looks poised to fall a lot more.

Like Fannie and Freddie, GMAC and its subsidiaries hold mortgages on a highly leveraged basis. As the mortgages default and the value of mortgages gets marked down, GMAC's lenders could demand the company put up more money in collateral, or GMAC could be forced to sell its mortgages at a loss to raise funds. Worst of all, it's unclear what obligations GM may owe to Cerberus in the event of a GMAC default or big write-off. Union boss Ron Gettelfinger, when asked about GM's exposure to GMAC and Cerberus said, "I think there are some issues there. I'm not real clear on it... Things have kind of unfolded here pretty quickly." Maybe someone should have sent Gettelfinger a copy of our chairman's letter. Those risks were very clear to us...

Mark Ernst, CEO of Extreme Value pick H&R Block (HRB), is stepping down. Richard Breeden, an activist investor with a 2% stake, will take over as chairman. Alan Bennett, who retired this year as chief financial officer of Aetna, is the interim chief executive. Ernst will remain with the company as a consultant.

An update to last week's "Buffett on the move"... We reported Berkshire Hathaway took a 6.4% stake in auto dealer, CarMax. To specify, GEICO, Berkshire's wholly owned insurance company, bought the 14 million shares. Lou Simpson, GEICO's chief investment officer, makes his investments without consulting Buffett.

Talk about a signing bonus... John Thain, the soon-to-be Merrill Lynch CEO, will receive $15 million for showing up to work on December 1. His first-year package, which includes 1.8 million stock options and 500,000 free shares, is estimated to be worth $64 million – not including the bonus. Merrill Lynch's shareholders are the biggest bunch of bagholders on Wall Street.

Plummeting financials have presented a buying opportunity... for insiders. Wachovia CEO Ken Thompson bought 100,000 shares of the bank yesterday, and two other insiders picked up an additional 150,000. American Express insiders bought 30,000 this month and 63,000 in August. These guys know their businesses better than anyone else, and their buying signals a bottom.

Inside Strategist editor Graham Summers noticed the insider buying in financials early on and has made some recommendations to profit from the trend. His latest recommendation comes out tomorrow. To read more from Graham, click here...

New high: Becton Dickinson (BDX).

A respite for you, and us, dear subscribers... The Digest will go on hiatus tomorrow and won't return until next Friday. We don't believe you'll miss us, and we hope you'll pardon our absence. We're hosting our annual S&A Alliance conference next week in Mexico. We will, however, continue to read our mail. So... don't let any of the Thanksgiving cheer prevent you from criticizing our efforts: feedback@stansberryresearch.com.

(Please note: To spare our readers the endless repetition, we are no longer publishing comments regarding our letter from the "chairman" of GM. You'll have to find something else to hammer us about...)

In today's mailbag, we move on to another issue we thought was simple... until we read our mail. Warren Buffett says we shouldn't be allowed to bequeath our assets as we see fit. He believes the government knows best. It seems a strange point of view from America's most successful investor. Dan Ferris commented on the issue in a recent DailyWealth... And our readers responded.

"I can do without the right wing ideology from Mr Dan Ferris. He happens to be quite wrong about the estate tax and offers an argument that is both shallow and disingenuous. Your service does provide some good investing ideas – but this kind of political propaganda disrespects your readers and undermines your credibility. Please leave the dishonest, right wing political crap to Fox News or I will have to drop this subscription." – Paid-up subscriber R Teasley

Porter comment: Believing my family should be allowed to control my estate (which has already been taxed several times over) upon my death is considered an extreme right-wing opinion? It's as if the original idea of America has been completely destroyed... and replaced by the global police state, Amerika.

"Dan Ferris's comments on 'Why Warren Buffett Is Dead Wrong About the Estate Tax' is unfortunately an ignorant view of reality and history. Those that have amassed great wealth have done so by using more of the public services to grow and protect that wealth and should pay for it. If they had to pay their fair price most would have gone bankrupt as many did during Feudal Europe. Secondly, this unfair distribution of wealth and control of the government policies as well as wallstreet does not allow people to grow the wealth that fairly reflects their contribution and eventually results to revolutions as it did in France, England and Russia, etc. Greed and selfishness is humanities biggest sickness and the barrier to a world that is in tune with its nature. Dan get well." – Paid-up subscriber George

Porter comment: Although I wouldn't consider myself rich, I'm sure if you looked on a comparison table I'd be above the national averages by a significant amount. With the exception of public roads (which are paid for through taxes on gasoline), I've only used public services when forced to do so... and I've regretted almost every encounter. Like most thinking people, I know anything that's done in association with the state will be a debacle. Meanwhile, I pay for these "privileges" through the nose, thanks to highly progressive state and federal taxes. Taxes are, by far, the single-largest expense I face both as an entrepreneur and a citizen. Does that make any sense?

The second part of your question assumes I've done something "unfair" to earn the wealth I struggle to keep away from the taxman. And, because it's unfair that I'm rich, my assets should be forfeited upon my death. I'd love to know what you think I've done that's unfair. Was it unfair that while my friends went to law school and got safe high-paying jobs at law firms, I earned below poverty line wages to get my first opportunity in financial research? Was it unfair that I risked bankruptcy to launch my own business? Was it unfair the way I've never accepted a penny from a business I've written about (which is common in our industry) and have always offered a money-back guarantee on every single one of our products? Lastly, you suggest greed only infects the wealthy. That's ridiculous. Nothing is as greedy as the man who cannot afford anything he wants.

"The communist party manual on organization by j. peters, states in part... 'we do not question the theory of the necessity for the forceful overthrow of capitalism.' It seems that buffett would do this without force by his support of the estate tax to redistribute the wealth of the producers of this great country." – Paid-up subscriber Anonymous

"Dan Ferris' column on Buffett is exactly correct, of course. I'm always glad to see that the men I take advice from share the same economic and political principles as I. For a moment I thought Mr. Ferris was about to quote Neil Peart, from the band Rush, but if he is not familiar with the damning lyrics on socialism in their song 'The Trees,' here they are:

There is unrest in the forest

There is trouble with the trees

For the maples want more sunlight

And the oaks ignore their pleas

The trouble with the maples

(and they're quite convinced they're right)

They say the oaks are just too lofty

And they grab up all the light

But the oaks can't help their feelings

If they like the way they're made

And they wonder why the maples

Cant be happy in their shade?

There is trouble in the forest

And the creatures all have fled

As the maples scream 'oppression!'

And the oaks, just shake their heads

So the maples formed a union

And demanded equal rights

the oaks are just too greedy

We will make them give us light

Now there's no more oak oppression

For they passed a noble law

And the trees are all kept equal

By hatchet,

Axe,

And saw..."

– Paid-up subscriber Jim Swanik

Ferris comment: That's exactly where I got the oaks/maples reference... I was a huge Rush fan as a teenager. In fact, the story in Rush's 2112 album is how I learned of Ayn Rand.

Regards,

Porter Stansberry

Baltimore, Maryland

November 20, 2007

A New Opportunity to Front-Run the Chinese

By Ian Davis

Too much money chasing too few investments...

That's the easiest way to explain the Shanghai stock market's 375% rally over the last two years.

You see, Chinese investors currently have about $2.3 trillion in household savings. With no developed pension, insurance, or bond markets, Chinese stocks are the only place available for them to invest that money. They are not allowed to invest overseas.

However, their little universe is slowly growing...

On August 20, China's currency regulators said that the mainland Chinese would eventually be allowed to invest in Hong Kong. (This still hasn't happened but it's supposedly on the way.)

Foreign speculators leaped at the chance to front-run the Chinese, buying up Hong Kong stocks left and right... Hong Kong's Hang Seng Index exploded upward by 49% in just three months.

Now's not the time to put more money into Hong Kong, but there is a way to play this upcoming trend...

Today, buying Taiwan is like buying Hong Kong back in August.

Currently, the Chinese are barred from investing in Taiwan's capital markets. However, all of that may be about to change. Taiwan is holding presidential elections next year...

Current president, Chen Shui-bian, has enraged China by pushing for Taiwan to join the United Nations as an independent nation state. But Chen will have to leave office since he's already served the maximum two terms. A new candidate will drastically improve Taiwan's relationship with China.

The two new candidates both favor closer ties and stronger economic links to China. "The Taiex should surpass its peak of 12,682 reached in February 1990 regardless of which party wins,'' said Johnny Chen, head of research at corporate investment banking firm BNP Paribas Securities (Taiwan) Co.

The Taiwan market should soar as we approach election-time. Friendlier ties with mainland China and the potential move toward reunification, will lead investors to bid up the Taiwanese stock market.

We could see a dramatic move if Taiwan's stock market behaves like Hong Kong's...

The chart above shows the price-to-earnings ratio of the Taiwan stock exchange in relation to the Hang Seng Index. As you can see, both exchanges traded at a P/E of around 15 until August, when China announced it would lift its Hong Kong restrictions. After the announcement, the Hang Seng's P/E quickly rose to 25 before backing off slightly.

You don't get many second-chances in life, but this may turn out to be one of them. If you missed the Hong Kong rally, then buy Taiwan instead. My Quant Trader readers are up 8% in the Taiwan Fund, and it's still a great buy. Taiwan is cheap, it's improving its ties with China, and it could be the next market to open its doors to mainland investors.

Until next time...

Good investing,

Ian Davis

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As of 06/25/2013