The S&A Digest: Why we hate the banks

Why we hate the banks... Merrill's accounting... Fannie's accounting... Hershey takes a hit... A top in Brazil's real?... Soros buys Lehman... Did you mean to short silver?

Merrill Lynch's shares are sagging again... And we think they will go much lower. Perhaps all the way to zero. Before we discuss why, we'd like to admit a prejudice...

We despise Wall Street's investment banks. All of them. We cannot understand why any individual investor would willingly do business with them. Large corporations pay these bankers to sell stock at the highest possible price to the public. Amazingly, the public lines up for the privilege, despite the well-known (and thoroughly proven) evidence that IPO shares garner poor returns. Investment banks have never seen an investment fad they couldn't take advantage of and have only rarely turned down an opportunity to blatantly defraud the public. And yet, SEC settlement after SEC settlement, they remain in business...

In Merrill's case, the big problem today won't surprise you: mortgages. Merrill – like Bear Stearns, Lehman, and Citigroup – was a leading underwriter of mortgage securities. Much of the toxic stuff remains on its balance sheet. Specifically, the company retains some $36 billion of securities backed by residential mortgages. At least its accountants claim these securities are worth $36 billion. We have strong doubts.

At the end of the second quarter, Merrill's accountants judged the value of another $30 billion (face value) in mortgage securities to be worth $11 billion. A few days later, these mortgages were "sold" to Lone Star Funds for $6.7 billion – a 40% difference. I've put sold in quotes because, to make the deal, Merrill had to put up 75% of the capital and offer terms it won't disclose. We don't think it's too much of a stretch to imagine the rest of Merrill's mortgage book might require another 40% haircut in order to generate a real bid – a real buyer using his own money for the purchase. If that's the case, Merrill is still holding onto paper losses greater than $14 billion. It has $16 billion of tangible equity left. That's cutting it pretty close...

And speaking of the walking dead, last weekend Barron's put a stamp of some authority on our conclusion that Fannie and Freddie's common stock will go to zero. But Barron's noticed something we missed in our June analysis. And it's a doozy...

Fannie and Freddie are artificially inflating their capital ratios by refusing to repurchase the defaulted mortgages they've promised to guarantee. Instead, they're only covering the required interest payments, postponing the ultimate day of reckoning. Nice work, Barron's – we wish we'd noticed that sleight of hand ourselves... Not that it makes any real difference to our conclusion. Take away the phony accounting and the company's tax loss assets, and they're both more than $50 billion in the hole – a hole they'll never come out of.

Signs of a top in commodity prices? Food and consumer-goods companies are hiring top commodities traders from trading houses like Bunge and Archer Daniels Midland. They're installing complex trading systems to help hedge input costs. Rising food costs are weighing on companies like PSIA pick Hershey (HSY). The chocolate manufacturer raised prices 13% in February, and today announced an additional 11% hike. Prices for cocoa, corn sweeteners, sugar, and peanuts have risen 20% to 45% since January.

Brazil's super-currency, the real, allows the country to import America's hottest celebrities to endorse local products... cheaper than local talent. One Sao Paulo- based ad agency landed Sarah Jessica Parker for a mall commercial for $600,000 less than top Brazilian entertainers charge.

Frivolous spending like this is contributing to a record account deficit, leading Goldman Sachs and Morgan Stanley to call a top in the real. Brazil's currency hit a nine-year high of 1.5545 per dollar on August 1 after rising prices for the country's commodity exports – soybeans, iron ore, and orange juice – fueled 25 straight quarters of economic growth. The currency is the top-gaining world currency in 2008 and the past four years.

Soros Fund Management, George Soros' hedge fund, upped its stake in Lehman Brothers from 10,000 shares at the end of March to almost 9.5 million shares at the end of June.

Soros is definitely in the minority on this trade. Very smart investors, including Dan Ferris, David Einhorn, and Whitney Tilson, are all short the investment bank – which is down 76% from its 52-week high. And some analysts are expecting the bank to lose $1.8 billion or more when Lehman announces earnings in two weeks. The bank will likely experience losses in its $50 billion portfolio of real estate and mortgage assets.

One thing to remember when you see a well-known, wealthy investor take a big position in a distressed company like Lehman: You don't know if he owns the company's bonds. Often investors (like Marty Whitman) who specialize in distressed companies will buy up common stock even when they expect a bankruptcy because owning a stake in the stock can help him win control of the creditor's committee in bankruptcy.

No more prostitution and weed in Florida foreclosed homes... Pasco County, Florida, officials will ask permission to use county jail inmates to help clean and mow lawns of foreclosed homes in the area. One official estimates Pasco has 6,000 foreclosed homes.

New highs: Baxter (BAX), Barr Pharma (BRL), Western Union (WU).

Yet another lull in the mailbag. Hopefully today's mention of George Soros will put the fire back in your belly. Send your rants to: feedback@stansberryresearch.com.

"Thanking you and your staff in sending your publications and the support we need in the midst of our unstable economy. Also, appreciate your gumption in expressing your honest view of what we are facing, along with your sense of humor. I am an Alliance member, so I receive a number of publications which serves as a learning process. I am more aware of what's going on in the financial world. What amazes me is the time your writers devote in traveling & writing the analysis. My husband is a near convert in reading your publications. Thanks again... keep writing & keep your humor, especially in our present uncertainty of time. I'll be looking for your next publication."

– Paid-up subscriber Clara Norman

"Porter, great call on silver. Down 40% or were we supposed to short it?" – Paid-up subscriber Doug Kroeker

Porter comment: My timing couldn't have been any worse. We were stopped out with a 25% loss. Unfortunately, that happens from time to time. On the other hand, my August recommendation to buy the shares of a certain bond insurer has already more than made up for the loss.

Regards,

Porter Stansberry

Baltimore, Maryland

August 18, 2008

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