The S&A Digest: "Worse than I thought"

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"Worse than I thought"... What we heard at Grant's... Lehman liquidates $1 billion... Soros' anti-free-market comment... Behind the doors of Moody's and S&P... Small banks failing... Beef in India?...

 "It's much worse than I thought..."

So said the $3 billion man at the Grant's Conference in New York on Tuesday. The "it" is the mortgage/housing crisis. Hedge fund CEO John Paulson identified roughly $14 trillion of various types of mortgage debt at risk, a much bigger number than the $1 trillion or so of subprime mortgages you hear about in the press.

But as I'll spell out in some detail in tomorrow's issue of Extreme Value, I believe the real number you should know about is higher still... more than $17 trillion.

And what if the total charge-off tops a mere 5%? That's more than $850 billion, versus the approximately $230 billion that's been written down so far. We're a little more than one-fourth of the way there, by this measure. Either way – and I speak for no one at Stansberry but myself – it is way too early to start calling a bottom in banks, mortgage companies, and the like. The crisis is much worse than most people think.

 Also in attendance at Grant's was David Einhorn, CEO of hedge fund Greenlight Capital. Einhorn is a nimble investor. He used to own 6% of the now-defunct subprime lender New Century Financial. He sat on its board. The crisis hit, he dumped his position and went short the credit markets.

Einhorn described a meeting with a recently retired senior exec at a large ratings agency. These companies – Standard & Poor's, Fitch, Moody's – have access to non-public info and are responsible for the credit rankings of investment banks. Einhorn asked the retired exec how his company evaluated the credit risk. Merrill Lynch had already announced large losses, so he asked what the rating team found on Merrill's books.

"He answered by asking me to refocus on what I meant by 'team.' He told me that the group covering the investment banks was only three or four people. They covered all of the banks. So they have no 'team' to send to Merrill for a thorough portfolio review. He explained that the agency doesn't even try to look at the actual portfolio because it changes so frequently that there would be no way to keep up."

Einhorn said the ratings agencies don't have any special models to evaluate risk. They use mostly publicly available information and look at basic ratios (like pretax margin). An S&P managing director who sat in the room as Einhorn spoke, left the room as Einhorn described the meeting. I wonder whom the managing director called once he had exited.

Einhorn is long "high-quality companies with low valuations that have little, if any, financial leverage." He mentioned Microsoft (MSFT) and Target (TGT).

 As if on cue, Lehman announced it liquidated three investment funds worth $1 billion yesterday.

 Like those at the Grant's conference, George Soros, the billionaire you love to hate, has told reporters the U.S. administration "failed to perform their job... This is a man-made crisis and it's made by this false belief that markets correct their own excesses. It will take much longer for the full effect of the decline in the housing market to be felt."

Did you catch that? "[F]alse belief that markets correct their own excesses..." Soros sounds like he wants to ride the "government-has-to-do-something" bandwagon. When times get tough, the "public" will clamor for the government to "do something." Whatever it does, it won't be good.

 The potential $850 billion of mortgage losses I mentioned above would be bad for many companies, but the U.S. economy could easily withstand it. Trouble is, the economy has to withstand the crisis and the toxic "medicine" of the federal doctors. That's a much bigger problem.

Think of the stock market crash of 1929. The U.S. economy contracted in its wake. So what did the government do? Among other things, it passed the Smoot-Hawley tariff, raising taxes on 20,000 or so imported goods. Other countries responded in kind, slamming the brakes on America's imports and exports. Even Canada passed new taxes on goods representing about 30% of its U.S.-originated imports. The Great Depression ensued... leading to still more government "solutions."

 Don't get me wrong. If you think community banks are a good place to look for investment ideas, I agree. But be vewy, vewy careful. The only two banks that have failed outright so far this year were small community banks, the largest of which had a mere $58 million of assets. It happened earlier this year. The FDIC had gone almost two years without closing a bank. I doubt that record will get broken again soon.

That the big banks are too big to fail is music to most people's ears, but it's a nails-on-chalkboard cacophony to me. It means the government will continue injecting new capital – literally creating new money out of thin air – and damn well seeing to it that the new money is as poorly invested as possible, by giving it not to the best capital allocators among us, but to the absolute worst, the bottom of the barrel.

 Banking and real estate are like bishops and funny hats. You just can't get them apart. Billionaire real estate mogul Sam Zell is not merely avoiding the U.S. real estate markets. He's avoiding most of the developed world. Zell sees the greatest opportunity developing middle-to-low income housing in places like Egypt, Chile, Mexico, China, and Brazil. Zell mentioned he owned some of Brazilian homebuilder Gafisa (GFA).

 How should you play credit-roiled markets in 2008? For the answer, we turn to our friend Chris Weber, the man who's never been wrong (not in the financial markets, anyway):

"I want to have roughly equal amounts in both cash and the precious metals complex. If you want to have stocks as well, then the ratio can be something like 40-40-20% (Cash-Metals-Stocks), or 45-45-10%. All we can really do now is to make sure we are protected against both inflation and deflation, and then sit back and watch what happens. This is truly uncharted territory. I know it is boring, and boring to repeat, but the best place for your money now is in cash, and in the major currencies. Hedge yourself by owning at least two of the major global currencies, the euro and the USD. But also feel free to buy any other major money. Don't worry that it doesn't pay much. I think this will be a year when the one who loses the least will win."

Chris is one of the investors we respect the most. He's never had a job, other than investing his money. To learn more about Chris, click here...

 I can't help repeating Chris' words here: "This is truly uncharted territory." Put that together with Paulson's "worse than I thought," and you better be extra careful about where your money is.

 What's Buffett buying now? Well, his most recently disclosed new position has been built up over the past six months. Buffett has bought a million shares of reinsurer Munich Re Group, according to a German newspaper report. Buffett bought 3% of Swiss Re in January.

 New highs: Stone Energy (SGY), XTO Energy (XTO), Sabine Royalty Trust (SBR), Pioneer Drilling (PDC), Comstock Resources (CRK), Plains Exploration (PXP).

 Knowing what we know about the biggest banks and investment banks' balance sheets and what David Einhorn has shown us about the ratings agencies poor review methods, I must ask, "Does anyone know anything about any bank in the United States?" And if so, will he/she/it/they please drop us a line? As always, you can do it at feedback@stansberryresearch.com.

 "I must say, it is off-the-wall stuff like this, 'Our best commodity recommendation? Get long heroin' that makes the whole Alliance membership worth it for me. Any ideas on how to implement this? Last I checked there wasn't a Heroin ETF yet. The pawnshop and strip club ideas have been entertaining as well. A little late to the game IMHO, but still great reading. Keep it up!" – Paid-up subscriber Robert

Ferris comment: You might enjoy Walter Block's Defending the Undefendable. It's all about pimps, hookers, drug dealers, and other capitalists.

 "[Burma] its one of south east asia's another coming tiger economy. given max 10 years, it will emerge. now is the time to look into it. the political climate is fast changing and stabililizing at the rate the drivers are expecting." – Paid-up subscriber Allen

 "You raised a very basic question concerning bonds vs stocks. The answer is bonds IF their return exceeds the rate of inflation. (The real rate of about 15%, not the phony data from the gov't statistics.) Since I see very few, if any, bonds that meet that criteria, I prefer stocks. Regarding leverage, some interesting stats were presented (32% to 45% leverage). But, if I understand how the bank operates, namely fractional reserve banking, the actual basis before the leverage (bank reserves) is a tiny fraction of the amount invested (I don't know the actual numbers offhand). So the inflation effect of leverage is only one part of the total inflation effect. If this is incorrect, please point out the errors." – Paid-up subscriber Fred Mocking

Ferris comment: I don't know about 15%, but it's certainly true – if you don't at least track inflation, then you're not making money, you're losing it. As far as Mike Williams' new fixed-income service goes, he's been around a long time. He's had more first-hand experience with inflation than anyone at Stansberry.

Also, that wasn't 32% leverage. It was leverage of 32 times tangible equity, like having $10,000 of equity on a $320,000 house. A 3% move in asset value wipes out equity. As for fractional reserve banking: Yes, money is literally lent into existence, but that's not inflationary in and of itself. Inflation is always the same: more money chasing after the same or smaller amount of goods.

 "Regarding what you said in Wednesday's Digest, 'But... sooner or later... the newly rich Chinese and Indians are going to want to buy protein," are you sure? Indians considered cows sacred. They don't eat meat! They might go for the soy beans, but cattle?" – Paid-up subscriber Luis Anderson

Ferris comment: This is a decent question, especially for people like me, who know nothing about India. I happen to recall, too, that the first McDonald's in India was also the first McDonald's that didn't have beef on the menu. Is beef served anywhere in India? I honestly can't say since I've never been there.

Regards,

Dan Ferris

Medford, Oregon

April 10, 2008

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