The S&A Digest: The end for Fannie and Freddie

The end for Fannie and Freddie... "Gay Barney" and "Dumbass Dodd"... OBAMA!'s "tax" plan... A new collectibles fund... The bond king pontificates... The test of a good analyst...

Man, I hate liars. The head of Fannie Mae told CNBC this morning that his company has more liquidity than ever before. While that may be technically true, it's the same kind of corporate newspeak GM has been spouting for years.

How much cash these companies have on hand is utterly meaningless in the context of their obligations and losses. Fannie and Freddie own or guarantee half of the mortgages in the U.S. According to Barron's, the real net worth of both companies is negative $50 billion. And the heads of both companies are meeting with the Treasury today to discuss a bailout, which will most likely wipe out shareholders. Meanwhile, the CEO says, "Everything's fine!" It's reprehensible.

The Treasury doesn't have any idea how big a problem it will inherit when it takes over Fannie and Freddie. The default rate on mortgages continues to increase.

Last Wednesday, Freddie Mac reported that 1.38% of its 2007-vintage loans are seriously delinquent after 18 months. An analysis of 2007 prime mortgages prepared by the FDIC on behalf of the Wall Street Journal showed nearly 1% of the loans were seriously delinquent after only 12 months. This indicates the 2007 mortgage pool will have much higher default rates than the disastrous 2006 pool, which had a default rate of "only" 0.38% at the 18-month mark.

Overall, we expect the total default rate on U.S. mortgages to reach 15%. Assuming a 60% loss on these loans (which is generous given the unprecedented increase in default rates and the growing supply of vacant homes), Fannie and Freddie could easily be over $500 billion in the hole by this time next year. But don't worry... 'cause everything's fine...

Who will pay for all of these losses? You know the answer, dear subscriber: you and me. And as you watch inflation soar, your taxes rise, and your standard of living fall, just remember all the people in Congress who ate at the Fannie and Freddie trough as they handed out liar loans like Christmas presents.

Together, Fannie and Freddie spent over $170 million lobbying Congress in the last 10 years. Where did the money go? Quite a bit went to Barney Frank and Chris Dodd. How much of the blame for the mortgage mess do you think "Gay Barney" and "Dumbass Dodd" will publicly accept? Zero. They will surely blame the catastrophe they helped create on "mean-spirited" mortgage bondholders who are foreclosing on properties.

Speaking of the utter corruption of our national politics... OBAMA! proposes to take things to a new level of absurdity and perversion. His "tax plan" has nothing to do with taxes. It's simply a plan to redistribute incomes according to his idea of "fairness."

Not surprisingly, OBAMA! thinks it's "fair" to take money from a small minority of citizens and give the cash to millions of other citizens, who will surely constitute a majority at the polls. What a concept! Just buy the election using the tax code!

Specifically, OBAMA! wants to make income taxes "refundable." What he means is, even if you don't pay taxes, you will still get cash from the government. For example, his "Savers Tax Credit" would match 50% of the first $1,000 people save – if they earn less than $75,000 per year. What about the fact that a couple earning $75,000 a year doesn't pay federal income taxes at all? No matter – instead of getting a tax credit, they'll simply get a check. The same goes for 50% of the first $6,000 poor families spend on health care. OBAMA! also wants to give $1,000 to each working couple and pay 10% of poor families' mortgages – all on a "refundable" basis.

What OBAMA! intends to do is create an entirely new class of working poor, all of whom will be utterly dependent on the government dole.

How will OBAMA! pay for this "fairness"? He can't, of course, without raising taxes significantly on the middle class. But he's still going to raise taxes on the upper income earners, even though he admits doing so won't increase total tax receipts. Why? Because he wants to promote "fairness."

Oh... one more thing. OBAMA!'s plan to "save" Social Security relies on raising the payroll tax by 32% for families earning more than $250,000 per year. Will this actually work? No. Every time you raise marginal tax rates on the rich, you decrease revenues because rich people can defer income or simply stop working.

But according to OBAMA!, even though these policies won't work, they're more "fair." OBAMA!'s plan represents the classic, ultimate problem of an unlimited democracy. It is always in the best interest of the majority to vote itself the rights and the property of the minority. But doing so destroys the fabric of the society, as incentives are perverted and respect for the law evaporates. You can eat the rich... but only once.

Steve Sjuggerud has been touting "the last cheap asset class," high-end collectibles, for six years. He's got vintage guitars and signed Beatles albums on his walls. He bought the first surfboard of Kelly Slater, the best surfer in the world, on eBay this year. The trick to investing in collectibles is only buying the rarest items. Rare collectibles are a great way to invest money with little correlation to the market. Now mainstream investors are catching on.

Marquee Capital and Anchorage Capital Partners, two London-based companies, plan to start the first investment funds devoted to music memorabilia. Marquee aims to amass the "world's largest portfolio of investment-grade Madonna and non-Madonna memorabilia." Anchorage is starting a vintage guitar fund. Both funds will launch next year.

While Extreme Value short pick Lehman Brothers is holding talks to sell off assets, it's also looking to raise capital abroad. Apparently, the bank failed to secure $5 billion in financing from South Korean sovereign wealth funds. One source says Lehman was trying to get more cash than Korea was willing to dole out. I'm surprised these funds would put any money into the U.S. banking system after how badly they've been burned already.

Pimco's Bill Gross believes the economy will continue shrinking through the first quarter of 2009. "It is all dependent upon housing prices to the extent that housing prices continue to roll down, then our economic system deleverages," Gross said. He's also bearish on the dollar: "The United States still has significant problems." According to Gross, the dollar's rise is "a function of the rest of the world slowing down when markets expected the rest of the world to do much better than it's doing now."

Another outspoken market commentator, Mark Mobius of Templeton Asset Management, says the commodities boom is still going strong, despite the recent selloff... "When you have a long-term uptrend, excesses build up along the way. We are witnessing a correction. Demand for commodities will remain at a high level in countries like China and India. If we see a serious worldwide recession, then we will see the end of the commodities boom." The Reuters-Jefferies CRB index, a basket of 19 commodities, has fallen about 17% since its peak in early July.

New highs: none.

In the mailbag... No, we don't buy the "it's a bear market" excuse. Good investors should be able to manage bear markets – and we've shown you how. Send your comments here: feedback@stansberryresearch.com.

"Well Porter, I can see that you do not have the competitive spirit of champions. As a former diving champion (in a low level collage conference), I can tell you that any athletic competitor will say that they are the best. If they do not believe they are the best, THEY WILL GET NOWHERE! Champions are made from confidence!!!!!!!!" – Paid-up subscriber Andy Kleinschnitz

Porter comment: Of the many derogatory things people have said of me over the years, no one has ever accused me of not being hypercompetitive. In fact, the most common compliment I receive is a complaint that I'm too competitive. And like you, I have some experience with success. I was part of a state champion water polo team in high school.

So I suppose your comment must be directed to Dan Ferris, who in a recent Digest was critical of an athlete's remark that winning three silver medals was "hard to take." Between you and me, I've always thought silver medals should come stamped with the word "loser" on them. Second place is for folks who didn't have enough heart to come in first.

"I have been investing in most of the picks that have been highlighted in both PSIA and True Wealth. I really enjoy these two subscriptions and have learned a lot about the companies and how to invest. I do some of my own homework and only invest in the stocks if it makes sense to me. I also have been using the 25% trailing stop loss method to make sure I don't have a catastrophic loss. I really like this method so thank you for showing it to me. So, the good news is that I am only losing 25% (or less if the stock goes up after I invest), but the bad news is that due to the bear market most of the stocks have declined, which is bad except for FNM and FRE which I did short and make/take profit on already. The problem now is that my portfolio has more stocks that have 'stopped out' and less 'winners' that are up more than 25%. In all, I've lost 25% of my initial investment (as this is the worst case scenario that's supposed to happen), but I'm just wondering that the problem here isn't so much the picks, but rather the fact that we're in a bear market (overall). I assume that when things turn around, then I will have more 'winners'. Any thoughts on this?" – Paid-up subscriber Chris Klein

Porter comment: I strongly disagree. You should not let the average return of the market dictate the results you expect from your portfolio. Otherwise, why do your own investing? Why not just buy an index fund? I expect our analysts to provide a positive return, no matter what the market does. Take my own track record, for example...

Given my belief we would enter a bear market (which I wrote about in the January 2008 issue of PSIA), I've used options (selling covered calls) and short sales to hedge my recommended portfolio. Out of the 15 recommendations I've made since the market peaked in November 2007, eight have either been short sells or have involved using options to hedge. Out of these picks, the average return is 17%. In the seven positions where I didn't hedge, our average loss is 4%. That includes both of our big losses: down 25% in Texas Instruments and down 27% in silver.

Overall, since the bear market began, my picks have produced an average gain of 7% in about nine months. Considering we've been able to add a few very high-quality companies (Hershey, Starbucks) to our portfolio at good prices, I'm confident the long-term results of our 2008 campaign will be excellent – despite the two big losses we've taken. And being up 7% on average during a significant bear market is a good result.

Finally, while average results are the true test of an analyst, getting big calls right – like predicting GM will go bankrupt – is also important and may be more valuable to subscribers. So far this year, I've made two big calls in my newsletter, PSIA: predicting Fannie and Freddie would go to zero and calling the bottom in the bond insurers. (I recommended a double position in one of them.) Both of these big calls have been stupendously profitable.

I'd like to know if any subscribers out there have been following my portfolio closely and have achieved good results, despite the bear market. E-mail me here: feedback@stansberryresearch.com.

Regards,

Porter Stansberry

Baltimore, Maryland

August 20, 2008

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