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Weekend Edition
The Best of The S&A Digest
October 4, 2008
 If you want to thoroughly understand the problem plaguing banks and brokers today, you ought to go back and read an issue of the S&A Digest I wrote in August 2007. Unfortunately, just about everything I feared might happen has come to pass.
As I explained in that essay – over a year ago – what's happening is a massive deleveraging of the global financial system. A global run on the bank. It's hard to know what will break next, but the Goldman fundraising and the failure of AIG have convinced me it's going to get worse, probably no matter what the government does.
Goldman wouldn't have cut the deal it did with Buffett – his annual return on his capital at risk will be about 28%, and he may eventually end up owning 10% of the company – if it had any chance of surviving without a massive amount of additional capital. That means Goldman's "marks" (the value of the assets on its balance sheet) are not nearly as good as it claims.
The failure of AIG means the credit default swap market – global credit insurance – has been completely destroyed. That's why the LIBOR (the main international interbank lending rate) keeps rising. All the banks know their peers are at risk of failing, and they have no way to insure credit risk anymore.
It's a mess. And a lot more banks are going to fail. Wachovia already has. I think Morgan Stanley will be next. These firms can't possibly sell their assets at any reasonable price.
Won't the government bailout solve all these problems by giving these firms cash in exchange for their mortgage assets? I doubt it. As you know, WaMu failed. Its doors wouldn't have opened if JPMorgan hadn't bought it for $2 billion. As part of the deal, JPMorgan will write off over $30 billion in mortgage assets. At current prices, selling its mortgage portfolio to the government wouldn't have saved WaMu.
Won't the FDIC protect us? WaMu failed with $188 billion in deposits. That's four times the entire FDIC reserve. And how many banks can JPMorgan and Bank of America afford to buy? Or will the government come in and pay full face value for mortgages now trading for less than 10 cents on the dollar? That's hard to imagine. How will the government raise $2 trillion in cash? What would happen to the value of the dollar?
If you're counting on the government bailout to work, you're putting your trust in the hands of Barney Frank and Chris Dodd, the men who brought you Fannie and Freddie's ever-expanding balance sheets and pushed no-down-payment lending onto the mortgage industry. These guys are complete clowns. Together, they're the two worst financial bunglers in the history of our government.
What should you do? Honestly, our advice hasn't changed:
You shouldn't hold much cash – no more than 5% of your assets – because the dollar is very likely to depreciate. Current interest rates aren't keeping pace with inflation.
You should own physical gold and silver (up to about 10% of your assets).
You should own carefully selected corporate bonds (up to 40% of your assets), if you can buy them at a substantial discount to face value. The bonds you buy should only be from companies with solid assets that you can understand. (You can look to our bond expert, Mike Williams, and his True Income advisory for help.)
Finally, you should own high-quality, blue-chip operating companies, like the kind I've been recommending in my newsletter, PSIA (up to 40% of your assets).
These firms can protect you from inflation because they'll be able to raise prices and increase their dividends. You should consider selling calls against these positions (as we've done in my letter) to generate income and hedge against any temporary price declines.
Regards,
S&A Research
Porter Stansberry writes and edits the daily S&A Digest, which comes free with a subscription to one of our premium products.
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