The S&A Digest: Socialize the risks, privatize the profits

Stansberry & Associates Top 10 Open Recommendations
(Top 10 highest-returning open positions across all S&A portfolios)

As of 07/08/2013

Socialize the risks, privatize the profits... The secret reason the government let Bear fail... Playing the 'bank game'... Didn't we use to call that 'socialism'?... The best way to buy gold... Mr. Biggs is bullish...

"This is a fine vodka event..." said one investment banker to the Wall Street Journal this weekend. He wasn't merely celebrating the collapse of a rival (Bear Stearns). As you surely know, JPMorgan will buy Bear Stearns for $2 a share in a deal that's actually a bailout in disguise. The deal went forward because the Fed lent $30 billion to JPMorgan to supply the capital and then guaranteed Bear's mortgage portfolio. (Officially, the Fed wouldn't disclose the terms of the financing or the agreement...) While the "bailout" of Bear will surely be the talk of the market this week, it's only a distraction. The real news is a major shift in Fed policy. The Fed, without any legislative authority, has decided for the first time ever to lend to "nonbanks" – securities dealers that do not accept deposits and are not regulated as banks.

Dealing securities is a business fraught with risk. It requires a tremendous amount of capital, as the primary dealers of securities must maintain large inventories. The largest Wall Street investment banks are always highly leveraged – 30 times debt to equity is about the average. Dealing in securities successfully also requires great skill. If you fill your book with garbage and you're leveraged 30-to-1, you will go broke extremely quickly, as Bear Stearns proved.

By agreeing to accept collateral (securities) from investment banks for 90-day loans, the Fed has put itself (and by extension, you and me) on the hook for the past underwriting decisions of Wall Street's investment banks, if they fail. In other words, the Fed is socializing the risks of dealing in securities, but keeping the profits "privatized."

The vodka swilling investment banker quoted by the Journal knows precisely what this means: Employing additional leverage no longer carries any risk because liquidity is always guaranteed by the Fed.

Why the sudden change in policy? Because the banks that normally lend money to securities dealers are very likely to call their loans over the next 30 days. Bear Stearns was scheduled to release its first-quarter report today. The results would have shown losses on its mortgage investments far greater than the total value of the firm. (It's estimated Bear's midtown Manhattan headquarters alone was worth $4 per share, not to mention its client lists, its prime brokerage business, etc.) Had Bear Stearns made these losses public, it would have caused a panic among the banks lending to the other securities dealers. And the other investment banks are all scheduled to announce their first-quarter losses shortly. It's a safe bet that most – if not all – of the major securities firms will be in danger of failing.

First up, Morgan Stanley. It's leveraged 32-to-1. It reports on Wednesday. But, thanks to the Fed, regardless of its paper losses, the other investment banks are unlikely to fail. An endless supply of new capital is now available courtesy of the U.S. taxpayer for only 3.5% annually. We're a generous lot, we taxpayers...

Bear Stearns was the only major securities dealer that refused to participate in the bailout of Long-Term Capital Management, the epicenter of the last credit crunch in 1998. This caused a lot of bad blood, as Bear didn't shoulder any of the capital costs associated with the bailout, but profited from the improved conditions in the marketplace. Wall Street viewed the firm as a "free rider." Had the Fed acted earlier, say last week, to accept collateral from securities dealers, Bear Stearns would not have collapsed, JPMorgan wouldn't have been able to buy the entire firm for $2, and investors in Bear wouldn't have lost $70 billion. The message to the market is undeniable: Do what the government tells you to do or else you'll pay, eventually.

And during all this, what was Bear's former CEO Jimmy Cayne doing? Playing bridge, of course. Cayne, who resigned in January, was pilloried for being at a bridge tournament in Nashville last July when the crisis first broke at Bear. Rather than resigning then, Cayne fired his deputy, who was his bridge partner and who was playing at the same tournament. And this time, as Bear spiraled toward bankruptcy, Cayne was in Detroit for the North American Bridge Championship. On Thursday, Cayne and a partner placed fourth out of 130. His performance slipped on Friday along with shares of Bear Stearns. He finished in 26th place, before heading back to New York to participate in the takeover talks. On Friday, Cayne's stake in Bear was worth $168 million. Today, it's worth a little more than $16.8 million.

Left unanswered in this situation are the real questions. Do we want our government to subsidize securities dealers? Do we want our government to have still more control over business, via its obvious power over banks and brokers? Do we want the Fed picking winners and losers on Wall Street? Didn't we use to call governments that owned the banks and controlled the major industries socialists? Isn't that what they do in France?...

As we say goodbye to Bear Stearns, we should remember how the firm ended up in this position: It bought mortgage securities from mortgage brokers and mortgage banks and provided capital to borrowers who should have never been extended a loan. The result was a housing bubble that inflated prices. Legitimate buyers were priced out of the market. Fraudulent buyers and highly leveraged speculators took over. The final outcome was never in doubt. The market had to crash, prices had to correct to become correlated once again with buyers' true incomes, and the folks who were so careless with their financing had to go bust. Home foreclosure filings in February were a whopping 60% higher than a year earlier.

The San Francisco Chronicle interviewed one of the many "homeowners" who were extended the courtesy of a mortgage, thanks to the absurd practices of investment banks like Bear Stearns:

A Discovery Bay man who asked not to be identified said he is "upside down" on his house by about $260,000. Instead of bemoaning the situation, he plans to capitalize on it. "I refinanced a couple of years ago and pulled out $100,000 and put in a fabulous pool," he said. "Now I've got this fabulous pool and fabulous house, but it's not worth anything. Why shouldn't I be building equity over the next four to five years instead of playing catch-up?" The man said he has not made a mortgage payment for five months. "I'm playing the bank game," he said. "I'm playing chicken with them. I already got them to agree to put (the unpaid) payments on the tail end of the loan. What I'm really pushing them to do is to (adjust my mortgage) for the current market value and write-off the rest. I'd love (to have it) lopped down to a $450,000 basis rather than $710,000." If the bank won't negotiate, he'll walk away, the man said.

It is mortgages like these, to people like the man from Discovery Bay, that the Fed is agreeing to accept as collateral for loans. The investment banks they're lending to cannot get credit in the free market because their collateral is deeply and obviously impaired. They are suffering huge losses, they're run by pedigreed, pompous fools, and they're leveraged 30-to-1. If you don't own gold or silver yet, what are you waiting for?

How do you buy precious metals? I prefer to buy plain, vanilla gold bullion coins. I can by them from my local dealer for just a point or two over the current spot price of gold. I also highly recommend Camino Coin (800-348-8001). If you don't want the hassle of dealing with physical gold or silver, you might buy into several ETFs, including GLD and SLV.

Or... if you're willing to specialize... you might buy rare gold coins or even mining stocks. In regard to the latter choices, you'll have to do your homework, but rare coins and mining stocks can give you huge returns that are many times larger than simply the increase in the price of gold. If that interests you, you'll want to know about the latest pick from our mining analyst, Matt Badiali. Says Matt:

Imagine a gold miner who had the foresight to invest in oil wells and who uses the oil proceeds to front the costs of mineral exploration. Right now, the company has less than a $300 million market cap. But it has a gold project that's better than Meadowbank, which Agnico Eagle bought for $700 million. And, to keep things moving forward, it has oil wells that bring in about $1 million per year. I would have never found this stock – it isn't covered by anyone else – but I heard about it from another Vancouver CEO. It's the ultimate insider tip...

To get Matt's research on small-cap oil and mineral firms, subscribe to S&A Prospector, here.

Wondering what your taxes will be during the next administration? It's a safe bet they'll be higher, no matter who wins. (And China isn't going to lend us money forever, without ever being paid back.) We can judge the market's expectations of future tax rates by looking at Intrade. According to the market, there's an 87% chance the top marginal rate will rise past 38% by 2011 and a 33% chance the top rate will exceed 40%. State taxes are going up too, of course – especially on the "rich." I put rich in quotes because income taxes do not actually tax the rich, who can structure their assets in ways that don't generate taxable income. Income taxes actually hurt entrepreneurs the most, people with small businesses who are working hard to become rich. By 2010, I expect most high-wage earners will be paying more than 50% of their income to the government. Didn't we use to call countries with tax rates as high as 50% socialists? Isn't that what they do in France?...

And we leave you with a dose of optimism... Hedge-fund manager Barton Biggs says the decline in U.S. stocks is "way overdone."

"We're in a financial panic," Biggs told Bloomberg. "We're setting up for a really big rally. I don't mean three or four hundred points on the Dow, I mean 1,000 points on the Dow. I don't know if we're going to get it next week or the week after. But this thing has gotten crazy and is overdone."

I'm bullish, too. I was buying financial stocks today...

New highs: EnCana (ECA), CurrencyShares Japanese Yen (FXY), streetTRACKS Gold (GLD).

In the mailbag, we'll allow one more day for the whole prostitution debate. But then we've got to move on to something more entertaining or more useful. Send your comments/questions here: feedback@stansberryresearch.com.

"Porter... The Florida sun has really cooked your brain. What a specious rebuttal you gave Dr. Lively. Prostitution is not a petty problem nor is it a victimless crime, nor is steroid use by professional athletes. They both harm society by influencing young, impressionable kids who might otherwise seek a more rewarding career in the long run, rather than a quick buck or instant gratification... You really need to get off your libertarian duff and spend more time getting out the vote for a Congress more to your liking. But then, as you've stated many times, you're not really much interested in politics. Well, even you can't have it both ways, Porter..." – Paid-up subscriber Robert

Porter comment: This has to be the most unique arguments we've gotten. You think prostitution should be a crime because you're afraid little girls will dream of becoming whores in the same way little boys dream of becoming ball players?

In regards to voting... You think by participating in a farce, I'm likely to improve it?

"Your argument is stupid! If you reason that the Government can't tell us how to behave or make laws governing citizen behavior you will have chaos. If prostitution is Ok, then drug use can be Ok. How about the poor person who robs a bank because he needs money is that going to be Ok too or how about the person who kills another person is that going to be Ok?" – Paid-up subscriber Bruce

Porter comment: Yes, without the government, how would we all get out of bed in the morning? Bruce, you might not realize this, but in most places in the world, private matters like prostitution and drug use are politely ignored. And you might be surprised to learn that those places endure far less violence and far less crime than in America. And they send far fewer people to prison.

"This is the worst invasion of personal privacy ever. A woman should be as free to set up in business and sell her services, as men are to buy them. We would do everyone a favor by getting our collective noses out of all things that people do in their private lives that do not harm others. Other societies past and present and other cultures have been able to live with prostitution, why are we so holy?" – Paid-up subscriber Robert Card

"Our country has become hung up on sex and Neocons are trying to tell everyone else what to do. So I guess they're not real conservatives... they're the worst of both what conservatives and liberals have to offer." – Anonymous

"I came across your August 2007 issue The Two Ways You'll Get Rich Investing and have a question regarding dividend reinvestment. In the issue, your friend Chris Weber points out that cash dividends are the only true way to compound an investment. He means using DRIPS (dividend reinvestment plans), correct? Right now, I'm gearing up my portfolio for the long run by buying stocks with name-recognition moats such as BUD, HOG, KO, NYT and WMT." – Paid-up subscriber Rob McIntosh

Porter comment: First, I applaud your strategy. I'm more and more convinced that buying the highest-quality, dividend-paying stocks for the long term is the one strategy that's most likely to work for the average investor and the one strategy that's most likely to create double-digit (10%-15%) annual compound returns. The trick, of course, is making sure the companies you buy have a permanent moat, are conservatively financed, and trade at a good price. (You'll find such stocks recommended in my newsletter, Porter Stansberry's Investment Advisory.)

Using DRIPS is a good way to set up your reinvestment – at least you'll know the dividends will be reinvested. On the other hand, I prefer to actively manage my reinvestments because I like to channel the income into the most attractive stock in my portfolio, not necessarily back into the company that issued it.

"I look forward to getting and I read The Digest every day and it is the most valuable part of my subscription. In it you sum up and clarify the big picture, which is key to the smart investor's outlook. Those of your subscribers who hastily disagree with you miss that. I also disagree sometimes, but that's what you're there to do: raise a point and look at it as truthfully and fully as possible. It seems to me that very few editors these days are bold enough to really make their readers think. In getting the Digest alone, I find the $6K that I paid for my Alliance ticket a good investment. Thanks, and keep raising and arguing the issues that you do." – Paid-up subscriber Joe Cisar

Regards,

Porter Stansberry

Baltimore, Maryland

March 17, 2008

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