The S&A Digest: Moody's might downgrade MBIA and Ambac

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Moody's might downgrade MBIA and Ambac... Another bank's failure... Lehman full of "cement"... Shortsellers: the real SEC... Home Depot up... Yahoo takeover saboteurs...

 At long last, Moody's says it might downgrade MBIA and Ambac Financial, the two leading and highly troubled bond insurers. Moody's thinks the new ratings will wind up around the double-A range, but says a single-A rating is possible. Frankly, I don't know how either company could be rated investment grade at this point, considering MBIA's 25-to-1 leverage, Ambac's 19-to-1 leverage, and the numerous subprime and structured finance bets they're both sitting on.

Both stocks hit new 52-week lows yesterday. MBIA is 92% off its 52-week high. Ambac is 97% below its 52-week peak. Moody's cited MBIA's low share price, saying that would make it tough to raise new capital. I don't normally care much about the short-term movements of securities prices. But... well... for example, ExxonMobil is a triple-A rated company. I'm fairly certain it's not controversial for me to predict its share price won't ever fall 97% in a matter of months. AAA stocks shouldn't fall 97% in less than a year. Even a dyed-in-the-wool, buy-it-all-the-way-down value player like me knows that.

 Speaking of falls and failures, I've been telling you to avoid investments in banks of any size and shape because I expect a wave of bank failures over the next couple of years. Today, a great article at WSJ.com describes what happens when the FDIC takes over a failed bank. A veritable SWAT team of regulators sneaks into town and shuts down the bank. It's the fourth time the FDIC has done this in 2008. That's once more than the previous three years combined.

At the bank covered in the WSJ piece, First Integrity Bank of Staples, Minnesota, bad loans doubled in the last 12 months. Many of the loans were against properties in... Florida.

If you think you're going to pick the bottom in bank stocks, you aren't. When it comes to investing in financial companies these days, you must heed the advice of Elmer Fudd: be veeewy, veeewy ceeehful. Today, bank failures are an interesting little sidelight. This time next year, they will be panicky headline stories.

 Whitney Tilson passed along this e-mail from a friend. It raises some scary points about Lehman, which I shorted in Extreme Value two months ago. If you aren't short Lehman yet, you will be after you read this...

A former Lehman partner told me why he is short Lehman in his personal account: "because their balance sheet is filled with cement." Formerly liquid assets are now illiquid (cement). My view on it is if these I-banks were hedge funds, they'd be on the list with the Amaranths of the world. No chance a 25:1 or 30:1 levered fund with 'cement' on its balance sheet survives this long. Certainly nobody is adding fresh equity capital to them. So, these pretend hedge funds somehow are treated with reverence by the same media that castigates much less levered, better managed hedge funds. Ironic. Somehow a manager like Greenlight that should be praised ends up on the negative end of an ugly innuendo piece.

Good point. If Lehman were a hedge fund instead of a public company, it would have evaporated into the great beyond, and somebody would have called Warren Buffett months ago, begging him to haul it away for pennies on the dollar. But it's a public company, and the SEC doesn't want to get caught doing a lousy job – again.

 Tilson also raises the point that many great short sales were criticized, mocked, and ignored by the press and regulators...

Jim Chanos blew the whistle on Enron, but did anyone pay attention? Bill Ackman nailed MBIA and Ambac five years ago, but nobody did anything (they ended up blowing themselves up). All sorts of people warned about the dangerous housing/mortgage bubble, but Greenspan and the Feds not only didn't do anything to stop it, but actively interfered with states' efforts to stop widespread obvious abuses and exploitation. Finally, David Einhorn documents in excruciating detail in his new book how he discovered all sorts of damning things about Allied Capital (which we're short), publicly shared his findings (all of which have proven to be correct to the best of my knowledge), yet all he got for his trouble was endless attacks, not only from the company (that's to be expected), but the press and, worst of all, regulators, who subpoenaed and harassed him for a long, long time.

Anybody who says the free market isn't self-regulating isn't paying attention. As the above messages strongly suggest, the market is often way ahead of the SEC in spotting problems. And, as David Einhorn pointed out recently, "The lack of confidence in the SEC's oversight ultimately undermines investor confidence."

But what can we expect? Calls for more government regulation, that's what. People don't want to be free. They want to be safe. By reversing this essential priority, they make life much more dangerous for all of us.

What should we have instead of the SEC? Gee, I don't know. When you remove a cancer, what do you put in its place?

 Insiders have been pouring into another Extreme Value stock, Home Depot (HD). Director David H. Batchelder bought more than 4.5 million shares since March. Insider buying is usually a bullish indicator for stocks because management (who knows everything about the company) bets with its own wallet. And Batchelder was right in this case. Today, Home Depot says it expects double-digit annual profit growth and revenue growth of 3% to 5% per year once the market calms. Shares jumped more than 3% on the news.

 It's amazing the lengths some CEOs will go to stay in power and hurt shareholders in the interim... Yahoo CEO Jerry Yang turned down a $40 per share offer from Microsoft – Yahoo currently trades at $26 – and even went behind the board's back to sabotage any takeover efforts. From Carl Icahn's letter to Yahoo Chairman Roy Bostock:

Viewing employee retention as Microsoft's Achilles heel, Yang engineered an ingenious defense creating huge incentives for a massive employee walkout in the aftermath of a change in control. The plan gives each of Yahoo's 14,000 full-time employees the right to quit his or her job and pocket generous termination benefits at any time during the two years following a takeover, by claiming a "substantive adverse alteration" in job duties or responsibilities. The damage to Microsoft "is compounded by the fact that Yahoo's thousands of engineers, known as 'Technical Yahoos!,' have detailed job responsibilities and qualifications."

 New highs: U.S. Natural Gas Fund (UNG), Potlatch (PCH).

 We got lots of responses to the Jeopardy question, but only a few correct answers. The correct response is AT&T. All three of the show's contestants guessed GE. Any other good financial trivia? Let us know at feedback@stansberryresearch.com.

 "Regarding Soros, whether one agrees with his political stance isn't relevant - The Digest mentions him when he makes statements regarding economic issues. His track record is enough for me to listen to what he's saying. To all those who lose their minds with rage whenever Soros is even mentioned, don't forget what Aristotle said: 'It is the mark of an educated mind to be able to entertain a thought without accepting it.'" – Paid-up subscriber Mike P.

 "Can you help me to better understand the risks associated with Puts? Most everything I read seems to indicate that there is a higher risk of loss with Puts than with Calls. One thing I don't understand; it seems to indicate that for some reason you can continue to lose money even after the option has been exercised. What am I missing? It seems to me that your loss is limited to having to buy the stock at whatever the price might be at that moment. Now I can see that it could be a lot of money, but some of the things I read tend to lead you to believe that you loss can be infinite. That seems absurd. I don't want to trade Puts until I have a better understanding of them and nothing I have read gives a really clear picture. I have read the tutorial provided by Steve Sjuggerud and Jeff Clark. It doesn't help me to understand this." – Paid-up subscriber Dave

Jeff Clark comment: I assume you're talking about selling naked puts versus selling naked calls. And in that case, puts involve less risk. In fact, selling puts actually involves less risk than buying shares of stock... if you're doing it right. Generally when you sell puts, you're agreeing to buy shares of stock below their current price, and you're being paid to take on that obligation.

So if you only sell puts on stocks you want to own anyway, and at prices you'd be willing to buy the stock, then your risk is less than that of buying the stock outright.

 The problem arises when traders try to sell puts on highflying stocks. Think about the shoe company Crocs (CROX), which traded for more than $70 a share last October. At the time, Crocs was valued at more than 80 times earnings. No one in his right mind buys a retail stock at that sort of valuation. But... The premiums traders can receive for selling puts on a stock at that price are very alluring. Traders who jumped at the premium (and committed themselves to buying CROX at, say, $50) found themselves in a world of hurt when the stock plummeted to less than $40 a month later.

 Today, CROX trades for around $10 per share and at just six times earnings. Selling the puts now is a much different story. You can either buy the stock here at $10, or you can sell puts on it and get paid to simply agree to buy the stock at $10.

 Selling puts generates current income. If the stock moves up you have no risk in buying the stock. And, if the stock moves down, then you're buying shares at a price you were willing to pay anyway – and you got paid to do it.

 "I made 80% in two days buying [Lehman Brothers] puts." – Paid-up subscriber DP

 "This is my second email. I'm wondering if you'll answer this. In backtracking back issues of Extreme Value, I finally found that Ferris had dropped RAIL, WLK, and Borders from it's portfolio. They simply disappeared from the portfolio in following months with no history of ever being recommended. I also noticed that an email was sent re. the sale of these stocks which I apparently never received. I'm a big boy and ultimately it's my responsibility. As luck would have it, I didn't sell and RAIL is up by 50% since Jan. and WLK is about the same as Jan. My question revolves around the integrity of not listing RAIL, WLK, and Borders in Extreme Value portfolio as sold positions. I'd also like to hear Dan's opinion of these stocks as value stocks since I still hold them. I believe in value investing but no one's perfect. Interested to see if you'll reply." – Paid-up subscriber Bill Eickhoff

Ferris comment: Sorry for the difficulties in using Extreme Value. The positions you ask about didn't "simply disappear" from the portfolio because (as you note) we did publish a "sell" notice. We e-mailed the advisory to all Extreme Value subscribers. We can't really know why you didn't receive yours, though you may want to contact your Internet provider to ensure it isn't filtering our e-mails.

As far as my opinion of these stocks, I regret selling FreightCar America – we sold it because we were down and didn't know how much farther it could go. But it's a fantastic company, with a fantastic competitive position, and a pristine balance sheet. Westlake Chemical should only have been bought under more dire sentiment. As for Borders, I made a mistake recommending it in the first place... It's just a troubled business that will probably never excel. That's the way things work out. We make mistakes. I know the positions we've gotten right in Extreme Value will far more than make up for these sells.

Regards,

Dan Ferris

Medford, Oregon

June 5, 2008

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