Weekend Edition
It's either worth 900% more... or nothing
Stanley Druckenmiller is hanging it up. Facing the first down year in a 30-year career as a hedge-fund manager (his main fund is down about 5% this year), Druckenmiller has decided to return his clients' capital and retire. We think you'll see more of this – that is, more hedge funds going out of business – as the global credit bubble deflates.
Druckenmiller's career happens to correlate perfectly with the largest inflation in history. As credit multiplied between 1980 and 2010, folks like Druckenmiller were paid unbelievable sums for managing the resulting capital flows. But... the credit spigot has been tightening up, at least for private capital.
Now, the only bubble left is the one getting blown up by Washington in the form of Treasury obligations.
Speaking of the credit bubble... here's an important trend worth watching: the battle over "reps and warranties." One of the primary reasons the housing bubble got so out of control (and why so many bad loans were made during the 2003-2007 period) is because securitization allowed mortgage originators to sell bad loans to other financial institutions. Originators didn't care about credit quality. They didn't hold the loans; they sold them. To protect the buyers of mortgage securities from fraud, originators had to agree to a series of legal representations ("reps") and provide a warranty against default for some period of time.
So... what's happening now with all of these bad loans, nearly all of which violated the representations made about their underwriting?
Most of these loans ended up on the books at Freddie and Fannie, which bought something like $400 billion in nonprime mortgages during 2005 and 2006. (As usual, the government agencies found a way to buy the worst mortgages at the worst time.)
As these two firms sort through the paper trails on all of their bad loans, they first contact the mortgage insurance firms – typically either MBIA or Ambac – to make a claim. The insurance companies then prove that the mortgage was fraudulently underwritten and deny coverage – something called rescission. At that point, Fannie and Freddie send a claim back to the originators, firms like Wachovia and Countrywide, which the surviving banks, Wells Fargo and Bank of America, now own.
As you can imagine, the whole process is like a game of hot potato. No one wants the liability for the potential losses on a defaulted mortgage. The underwriter denies any claim of fraud and argues the mortgage was properly insured. The insurance companies claim fraud. And Fannie and Freddie say it's not their fault, it's the underwriter's responsibility.
Things were pretty much at a legal standstill until Fannie and Freddie's newest regulator got involved and sent subpoenas to 64 mortgage underwriters. That's when the proverbial "stuff" hit the fan.
Analysis by Chris Gamaitoni of Compass Point Research & Trading predicts massive additional undisclosed losses at Bank of America, Wells Fargo, JPMorgan, and Citigroup – led by $7 billion at Wells Fargo. Total losses (both disclosed and undisclosed) due to reps and warranties could be as high as $17 billion at Bank of America.
There's a flip side to these losses, however – the matching decline of liabilities at the mortgage insurance companies. Check out MBIA, for example. It's a $2 billion market cap mortgage and municipal bond insurance company. It holds almost $35 billion in assets, including about $3 billion in cash. On the other side of its balance sheet, however, are more than $20 billion insured losses, mostly mortgage insurance claims.
Every dollar of insured losses that MBIA is able to rescind because of reps and warranties is probably worth $5 or $6 in market cap. If you were able to rescind half of the $20 billion in mortgage losses, you'd probably see the stock trading closer to $60 than $6.
There's another factor to consider... The need to paper over the enormous legacy losses of the housing bubble is what explains the Fed's policy of zero percent interest rates. Right now, it costs the banks almost nothing for capital, which means huge profits on loans. The profits are necessary to make sure they can afford the legacy housing bubble losses.
What's not a part of this calculation is the true cost of zero percent interest rates. In that environment, people have little reason to save or invest. Can our economy survive zero percent interest rates and an avalanche of new paper dollars? We don't know.
Regards,
Porter Stansberry
Editor's note: The Weekend Edition is pulled from the daily S&A Digest, produced by Stansberry & Associates. The Digest comes free with a subscription to Porter's Investment Advisory. To learn more about Porter's research, click here.
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