For the past two years, the U.S. government has given banks a free pass to mint cash. The Fed has maintained the federal-funds rate near zero, allowing banks to borrow money for virtually nothing. Meanwhile, the Fed's "quantitative easing" has put upward pressure on long-term interest rates (as measured by 10-year Treasuries). Treasury rates bottomed at 2.07% on December 18, 2008. Today, the 10-year has rebounded to 3.75%. That's a 168-basis-point increase. As long as the long-term rates increase and the short-term rates stay near zero, banks will make more money on their loans. And right now, banks are making a killing borrowing money from the government for free and lending at more than 5%.
It was the government's plan to let banks repair their balance sheets, then start lending more cash to boost the economy. And the $2.7 trillion of fresh capital the government created is also working to prop up business and consumer spending. We're in the midst of a debt-fueled euphoria... The stock market is soaring, companies are making record profits, people are spending money again.
But you can't solve a debt problem by creating more debt. Eventually, inflation will kick in and bring this party to a stop. But as former Citi CEO Chuck Prince said just months before the crash, "As long as the music is playing, you've got to get up and dance." The music is playing again. Everybody is making money. It's no surprise the latest batch of earnings announcements was stellar.
Morgan Stanley beat analysts' expectations, earning $1.4 billion for the quarter, compared to a $578 million loss a year earlier. As with every other investment bank, the number was driven by record earnings in the fixed-income department. Morgan Stanley's fixed-income sales and trading revenues more than doubled to $2.7 billion from $1.2 billion a year ago.
The San Francisco-based consumer-lending giant Wells Fargo also beat expectations. Earnings fell 1% to $2.37 billion. Credit losses improved by $83 million to $5.3 billion, spurring Wells to believe the economy has turned the corner. (Slowing mortgage originations did hurt the bank.)
12% Letter pick McDonald's earned $1.09 billion for the quarter, up from $979.5 million a year ago. Global sales for the fast-food behemoth rose 4.2%. The gains were largely driven by the company's foray into premium coffee.
The biggest market boost today came from Apple. Quarterly profit soared 90% to $3.07 billion and revenues rose 49% to $13.5 billion. According to Steve Jobs, it was the "best nonholiday quarter revenue ever." Once again, the iPhone drove Apple's performance. The company shipped 8.75 million iPhones in the quarter – a 131% increase from last year's 3.79 million. In total, phone sales made up 40% of total revenue.
Apple also saw huge growth in China, where analysts initially expected difficulties. Chinese iPhone sales increased more than nine times. Overall revenue in the region tripled to nearly $1.3 billion. Shares are up nearly 6%. With a current market cap of a little more than $234 billion, Apple is now the third-largest publicly traded company in the U.S. behind Microsoft and ExxonMobil.
I just realized something that changes my opinion about the SEC's Goldman lawsuit. The case revolves around a synthetic commercialized debt obligation (CDO). These investors (a German bank and a small mortgage insurance company) weren't buying actual mortgage securities. They were agreeing to assume the risk of insuring mortgage bonds in exchange for annual insurance premiums. Therefore, they had to have known some other investor – whether it was Paulson or another hedge fund – wanted to buy insurance on these mortgages. Said another way, unless someone wanted to short these mortgages and was willing to pay the insurance premiums to do it, no financial instrument could have existed for the bank and the insurance company to buy.
Thus, the case will likely come down to whether or not the fact that Paulson & Co was the buyer of the credit default swap was material information. My bet is it wasn't. And even if the court decides it was, plenty of evidence suggests at least one of the CDO buyers knew Paulson was paying for the insurance: John Paulson's former mortgage analyst, Paolo Pellegrini, says he told ACA Management Paulson intended to short the mortgages.
The more I learn about the Goldman lawsuit, the more interesting it becomes. I couldn't believe the SEC would actually take on Goldman or any of the big banks. The banks are the SEC's patrons. The SEC's real purpose in life is to protect the banks (not you and me). Now, it seems clear to me suing Goldman about this issue – a case involving a synthetic CDO that the regulator will probably lose – is simply raising a red herring. Left unexamined is the much larger issue: the extraordinary amount of fraud in mortgage underwriting between 2004 and 2007.
In these deals, Goldman bought mortgages it knew (or should have known) would default, packaged them into securities, and bought insurance on them from AIG. That caused AIG's collapse and the subsequent $200 billion government bailout. My bet is you'll never see any investigation into these deals or any investigation into the huge number of Fannie and Freddie securitized mortgages that have defaulted, costing U.S. taxpayers $400 billion, so far.
We wrote it, did you buy it?
More credit-card charge-offs will mean lower prices [for charged off credit-card debt portfolios]. Buyers will be fewer. And those with capital, like Portfolio Recovery, will have an advantage. – Dan Ferris, Extreme Value, November 2008
The Nilson Report, the premier credit-card industry trade publication, recently confirmed Dan's prediction of lower prices for charged-off credit-card debt, "[T]he price that buyers were willing to pay for fresh charged-off debt continued to fall throughout the year. The price for fresh debt charge-offs that are 180 days past due fell to as low as 4.0 [cents] on the dollar by the end of 2009. Prices had peaked at 13.5 [cents] on the dollar at the end of 2006..."
Dan recommended Portfolio Recovery Associates in November 2008 at $35.11 a share. It closed yesterday at a new high of $60 a share. Extreme Value readers are up 71%. Portfolio bought $8.1 billion of debt last year for $288.9 million, less than $0.04 per dollar of face value. That's about 77% more debt than it bought in 2008. As Dan expected, Portfolio took advantage of lower pricing to buy more debt. And that cheap, new debt will result in huge free cash flow and earnings over the next few years.
Lately, Dan has discovered two brand new small-cap financial stocks that will take advantage of failed bank loan portfolios... The same way his Portfolio Recovery pick is taking advantage of lower pricing on credit-card portfolios. These two banks have more than three times the capital required by law. They're two of the safest, best-managed banks in the country, if not the world. They could easily double or triple over the next few years as the FDIC assists them in buying failed bank assets and deposits. The FDIC lets them buy the assets at an 20% discount... then agrees to cover 80% of the losses. It's hard to lose money with a deal like that. When banks do these deals, they book an instant profit, sometimes tens of millions of dollars worth. To get access to Extreme Value, including Dan's two new small-cap bank picks, click here.
New highs: Powershares Dynamic Biotech Fund (PBE), Hershey (HSY), ConocoPhillips (COP), Amerigas Partners (APU), McDonald's (MCD), Kinder Morgan Energy Partners (KMP), Altria (MO), Microsoft (MSFT), Banco Latinoamericano (BLX), W.R. Berkley (WRB), Automatic Data Processing (ADP), Portfolio Recovery Associates (PRAA), WD-40 (WDFC), Brady Corp (BRC), Shaw Group (SHAW), Teleflex (TFX), Rowan Drilling (RDC), Carbo Ceramics (CRR).
In the mailbag... nothing puts us in a more generous or expansive mood than subscribers threatening to insult us if we don't immediately stop everything else we're doing and answer their request for free advice immediately... Send us your questions here: feedback@stansberryresearch.com. We promise to read all of your notes... but we reserve the right to ignore you.
"This is the fourth time I've written in with the same question. Are you ever going to answer me or should I just tell you to shove it where the Sun doesn't shine???? Is there a way to buy puts (or another strategy) to make money when the S&P 500, Nasdaq, or the Dow declines? A way that doesn't cost a fortune that is." – Paid-up subscriber Gary
Porter comment: Yes, there is. Try reading either my Put Strategy Report or Jeff Clark's S&A Short Report for details. Also, look for a new trading service designed especially to serve subscribers who are on a fixed income: Retirement Trader, which will be written by our ex-Goldman derivatives ace, Dr. David Eifrig.
"It is interesting to note that Biglari Holdings is among the new highs in The S&A Digest dated 4/20 at 6:04 PM, yet my brokerage page shows that today's close is 11.74 -2.84%. Do you get the new highs from some date other than the date of the Digest?" – Paid-up subscriber Charles
Goldsmith comment: The new highs are from the previous day's close because we write The Digest during the trading day.
"Great call on Goldman, Porter! The thing I find interesting about the lawsuit is that it came on expiration day. Someone (or sometwo, or three) in the know made a killing on out-of-the-money puts. Will the SEC investigate that? I'm not betting on it." – Paid-up subscriber Rich Gustafson
Porter comment: Ah, that's a very astute observation. Nothing like ripping the faces off the public, while pretending to protect it.
Regards,
Porter Stansberry and Sean Goldsmith
Baltimore, Maryland
April 21, 2010