Trying to get cash

Trying to get cash... GE swims naked, too?... Banks to make up numbers (again)... Buffett on accounting... Bill Miller, poor bastard... Car dealers go bust... Paying the vig in Vegas... Ferris warns on Sovereign... Ain't no gold... Wrestling with quadriplegics...

True story: Driving back from Hatteras, North Carolina, last weekend, I saw three armored cars on the highway. I've never seen an armored car on the interstate before, as far as I can remember. And certainly not three of them on a Saturday. Moving cash around on a weekend? Mmmn...

So on Monday morning, I called my banker at Bank of America. "I'd like to pick up $100,000 in cash today," I told her. Can't. It's not here. She told me the soonest I could get the money was Friday, because they'd have to order it. Not what I had in mind. (Remember, I can get almost any book in print sent to me next day, courtesy of Amazon.com. But cash? Won't arrive until Friday.)

"Well, how much can I get on my ATM card?" I asked. Only $10,000 per day. Not good enough. So... how can I actually take a large sum of money out of the banking system on short notice? You can't. Your savings and checking accounts might be called "demand deposits," but watch what happens when you actually demand your money back. You can't get it. Not quickly, anyways. I ended up wiring the money to a gold bullion dealer and paying a large premium (4%) to get gold in a very tight market.

Buffett likes to say of the financial industry, "You never know who is swimming naked until the tide goes out." We'd been convinced for a long time that Goldman Sachs was "swimming naked." And when the tide finally went out, we were right. But the list of naked swimmers might be a lot longer than we thought. As we're typing today's Digest, word is coming out that General Electric has gone hat in hand to Berkshire and sold preferred stock, while simultaneously going to the public to sell a huge new chunk of equity – $12 billion.

On the last day of the third quarter, the SEC suddenly decided to relent on mark-to-market accounting, which forces financial firms to value their assets based on current prices in the marketplace. Now, management teams will be allowed to disregard current prices on things like their mortgage securities, if they believe the current market prices are based on "distressed sales." Never mind that the falling quality of those same assets is causing the distress in the marketplace in the first place.

Boy, wouldn't it be nice if we could all follow these kinds of rules. Imagine if you could tell the police you were speeding because you were in a hurry... Do you have a monthly sales quota? Ah, nevermind. Just tell your boss how much you think you could have sold if conditions were better... I wish I'd had the SEC as my principal at Winter Park High School. We could have just made up whatever grades we felt we deserved...

As we've been warning you, the investment banks – Goldman Sachs, in particular – have been making up the numbers on their income statements for years. There's no way to make the income statements match the cash-flow numbers, not unless you fudge the balance sheets. And that's what's about to happen – just before Uncle Sam buys a bunch of assets off those same balance sheets. What a crime.

Here's what Warren Buffett said at his last annual meeting about the importance of using accurate market prices when valuing a bank's assets (thanks to the invaluable Outstanding Investor Digest for the transcript):

I think the discipline, mild as it may be, of telling managements that they're going to have to value this stuff at market may keep them from doing very stupid things that they'd otherwise do if they think they can get away with valuations at cost. So I lean toward the market value approach.

Considering all the stupid things the banks have done already, it's hard to believe they're capable of doing even worse things. But I'm sure they'll find a way. Why not? No matter what they do, the taxpayers will bail them out...

But... let's move on to the other major industry receiving billions from Uncle Sam – the carmakers. Ford reports sales of trucks and SUVs fell 39% and 57%, respectively, in September compared to last year. Ford's overall September sales were down 35%. Total new vehicle sales (from all makers) might drop below 1 million units per month, the slowest sales volumes since February 1993 – 15 years ago.

Also, earlier this week, the largest Chevy dealer in the United States, Bill Heard Enterprises, went bankrupt. It's the eighth car dealer to go bust so far this year. It went under owing more than $200 million to three major creditors: GMAC, BMW, and JPMorgan.

Finally... no matter how poorly your investments have done this year, I'd be willing to bet Bill Miller has done a lot worse. He bought Fannie, Freddie, and AIG all the way down. And that was after making huge bets on homebuilders and Bear Stearns. There's hardly been a bankruptcy in the past several years he hasn't owned. His fund is down to $8 billion in assets from $20.6 billion in June 2007. And he's finally decided to change his investment style. Essentially, rather than buying stocks all the way down, he's just going to mirror the S&P 500. He says GE and Wells Fargo look "safe and cheap." (I'd avoid both stocks just because Miller is buying.)

You might recall we've been writing about the lack of gold and silver bullion supplies for several weeks. Many of our dear subscribers thought we were nuts... crazy conspiracy theorists... cranks. Meanwhile, our sources in the market told us the supply constraint was real and the spot price for gold was no longer accurate in regard to bullion prices. There just wasn't any gold on the market at current prices. Well, last week the U.S. mint said it would stop selling one-ounce bullion coins after soaring demand depleted inventories. Our advice? Get your gold while you still can. And put it someplace the government won't be able to find it.

PSIA subscribers may recall my gloomy take on Las Vegas earlier this year:

Las Vegas may end up being the single-largest source of mortgage defaults. Upscale home prices here have fallen nearly 40%. The $2 billion Cosmopolitan hotel development is in default. The $6 billion Las Vegas Plaza is being delayed. Even Donald Trump has put his second tower on hold. It's a bloody mess.

Meanwhile, City Center, a $9.2 billion condominium/hotel development on the strip, is still going up.

This is the largest privately financed development in the history of the United States. It sits in the middle of a desert, in a city whose economy is dominated by gambling. Those two facts alone would give most reasonable investors pause.

The entire complex is five-star. One-bedroom condos here sold for $700,000. And the complex includes literally thousands of them. What will they be worth in foreclosure? I'd bet less than $200,000. And who will absorb those losses? I can't help but think in another two years we will look at those buildings and wonder, "What were they thinking?" – July 2008, PSIA

Today, Las Vegas' richest man, Sheldon Adelson – chairman and CEO of Las Vegas Sands – personally bailed out his company with a $475 million investment. Of course, Adelson is calling the cash an "investment," for which he'll receive convertible senior notes in return.

Yesterday, Dan reported on a great arbitrage opportunity in Constellation Energy shares after they dipped below $17 – Warren Buffett has a $26.50 outstanding offer for the shares. Our friend Peter Lacey sent us a note explaining why it happened. A trade publication, SparkSpread.com, published a report saying Constellation would file for bankruptcy. It caused such an uproar, Constellation released a statement Monday saying the merger was on track. Shares recovered and closed the day at $23.

Dan also sent me something from footnoted.org about Sovereign Bancorp, a troubled regional bank we've warned is very likely to fail. "Yesterday, Sovereign Bancorp announced a series of management changes, including the departure of its CEO, Joseph P. Campanelli by the end of the day..." Also, Moody's yesterday downgraded Sovereign's credit rating. According to the Wall Street Journal, the bank is exposed to a number of problematic asset portfolios including Fannie and Freddie. We'd bet it doesn't last through the weekend.

New highs: Nope. Not yet.

In the mailbag, something we love: a really nasty personal attack on some of our recent analysis. But we're confident you'll see things our way. After all, as Charlie Munger likes to say, you're smart. And I'm right. Want to argue? Kick us in the teeth here: feedback@stansberryresearch.com.

"Speaking of people who can't add and can't read balance sheets (as you so often do), go take a look in the mirror, get a copy of the Wachovia annual report, latest 10-Q, and the 9/29 press release describing the transaction, take them to your friend Steve Sjuggerud, who does seem to know how to add and read balance sheets, and ask him to explain the transaction to you. Citicorp assumed about $800 billion in assets and an equal amount of liabilities. The $312 billion loan portfolio you mention is part of the $800 billion in assets, while the $447 billion in deposits that Dan Ferris mentions and the $60 billion in senior debt you mention are part of the liabilities.

"Apparently you didn't read the press release very well, or you might have noticed that the FDIC receives $10 billion in Citicorp preferred stock, in addition to the $2 billion in common stock issued to the surviving Wachovia. These of course are also part of the liabilities. So what happened to the rest of Wachovia's capital of about $75 billion reported in the 10-Q for second quarter? The press release doesn't really address this, but my guess is that the loan portfolio was written down by about $61 billion, which will augment Citicorp's own loan loss reserve, and Wachovia was allowed to keep the remaining $2 billion, in addition to the stock it receives from Citicorp. Citicorp also gets Wachovia's own loan loss reserves of about $11 billion, so it's total reserves against the acquired portfolio are about $72 billion.

"Good deal for Citibank? Probably, but not a $220 billion windfall. Good deal for the FDIC? Probably, the $10 billion in preferred stock means their exposure starts at $51 billion ($41 billion Citicorp agreed to eat, and the $10 billion in stock), which is actually better than the situation they would be looking at if Wachovia had failed. Good deal for Wachovia? Terrible deal for Wachovia, but better than the fate they faced by hanging on. They are now a retail brokerage (A.G. Edwards) and an asset manager (Evergreen Funds). Face it, Porter, you do not understand banking, and you jump to unfounded conclusions." – Paid-up subscriber Philip Crawford

"'Citigroup will get $270 billion in loans in exchange for $50 billion in debt. The government just gave Citigroup about $220 billion in value, risk free, plus one of the largest retail banking networks in the world.' Porter, your analytical skills may need an accounting 101 refresher course. I'm afraid you have forgotten the difference between 'assets' and 'equity.'" – Paid-up subscriber JR

Porter comment: Here we go again, wrestling with quadriplegics...

The deal Citi got is the steal of the decade. Arguing about the fine points is irrelevant. But just because I like to argue, let me count the ways you're both wrong...

First, Citi didn't buy Wachovia; it bought Wachovia's banking operations and assumed the holding company's debts. That's why your 10k numbers don't match the press release numbers. Second, you're both forgetting a crucial point: Citi didn't put up any cash – not a single penny. And that changes the real-life expense of the transaction. Citi took on $54 billion in Wachovia debt and paid another $2 billion in stock for the banking operations. Again, it didn't pay a single penny in cash. That matters because the deposits and the assets Citi is getting will finance the repayment of the debt it assumed. Thus, after paying nothing, it has received far more value than the $2 billion in stock it "paid."

The real likely cost of this deal lies in Wachovia's troubled loans. About half of Wachovia's loan book ($312 billion, to be precise) is experiencing very high default rates. Considering Citigroup hasn't actually paid anything to get these loans, if they all defaulted it wouldn't hurt Citi. But to sweeten the deal, the government offered to sell Citi "insurance" on $270 billion of these debts. Thus, after spending a mere $10 billion (again in stock) on "insurance," Citi will wind up with $270 billion of guaranteed loans for which it has literally not spent a single penny. If that's not a gift, what is it? We might argue about whether it's a $270 billion gift, a $200 billion gift, or maybe just a $100 billion gift. It all depends on the present value of the loans it has assumed and the value of the warrants that went along with the stock for the government. But it's still a huge, huge amount of money. Citigroup's entire market cap prior to the deal was only $100 billion.

"One of the biggest gold dealers in North America is the Bank of Nova Scotia with branches all over Canada. One of my tax clients has been buying gold and silver bars and coins there for the last few years and selling them back with no problem whatever. Go in to your local branch and see for yourself." – Paid-up subscriber David

Regards,

Porter Stansberry

Baltimore, Maryland

October 1, 2008

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