Wealth Building Lessons

What a day for financial stocks! Regional banks got slaughtered and even large national banks sank like bricks. Washington Mutual (WM) was down 35% and Wachovia (WB) dropped 15%. I guess the market didn’t care for the Federal Reserve’s bailout of Fannie Mae (FNM) and Freddie Mac (FRE).

So should the Federal Reserve have offered to bailout FNM and FRE in the first place?

FNM and FRE own 80% of the countries estimated $7 Trillion mortgages, which works out to be $5.6 Trillion. However, they have less than $260 Billion in cash, which means their portfolio is leveraged more than 20 times. When you’re leveraged 20 times, a 5% default rate can wipe you out. (Remember Bear Sterns buy out at $2 a share? They witnessed this first hand). Based on this over-leveraging, many investors believe that FNM and FRE are already bankrupt.

IndyMac, a Pasadena-based bank, collapsed as the value of its mortgages that defaulted exceeded the value of cash reserves it had on hand. Of course, FDIC stepped in to bail out the bank’s customers, up to $100,000 in deposits. IndyMac had $18 Billion in deposits. However, after liquidating the bank’s $32 Billion worth of assets, the FDIC will have to chip in another $4-8 Billion to make sure the $18 Billion gets returned.

Assuming the worst-case scenario of $8 Billion, the liquidation value of IndyMac’s $32 billion of assets is only $10 billion. In other words, the true market value of IndyMac’s assets is only 31% of its stated book value. In the FDIC’s best-case scenario, the liquidation value of IndyMac’s $32 billion of assets is $14 billion, which is still only 44% of its stated book value. [Source: John Turk]

Based on this liquidation analysis of IndyMac, it looks like the actual true value of subprime and Alt-A mortgage debt still in the banking system is something less than 50% of stated book value? Looks like a lot of banks are going to go bankrupt!

And considering that the FDIC has just shelled out 10% of its cash reserves for IndyMac’s customers, I don’t know how many more bank failures it can handle until the Fed has to bail it out!

So the question remains, should the Fed have bailed out FNM & FRE? According to some reports, this bailout will end up costing the American Taxpayer $1 Trillion over the next few years. And its not like the government has this sort of money lying around. It already has future debt obligations worth nearly $60 Trillion and the interest payments on our federal debt is over $1 Billion per day!

Some people think that FNM & FRE are so big that the government just has to bail them out.

However, others like Jim Rogers think this is “an unmitigated disaster”. “I don’t know where these guys get the audacity to take our money, taxpayer money, and buy stock in Fannie Mae,” said Jim Rogers in a Bloomberg interview from Singapore. “So we’re going to bail out everybody else in the world. And it ruins the Federal Reserve’s balance sheet and it makes the dollar more vulnerable and it increases inflation”.

“These companies were going to go bankrupt if [the government agencies] hadn’t stepped in to do something, and they should’ve gone bankrupt with all of the mistakes they’ve made. What’s going to happen three years from now, when the situation’s much, much, much worse… They’re ruining what has been one of the greatest economies in the world… there are 300 million Americans that are going to have to pay for this”.

A lot of people are agreeing with Rogers. Chris Dodd, the Chairman of the Senate Banking Committee, is behind the Congress’s mortgage bailout solution. According Porter Stansberry, editor of an investment newsletter, “Chris Dodd, is truly one of the stupidest people in all of public life. And by the way, I don’t mean that rhetorically. I mean literally….he’s dumb as a box of nails”. Stansberry thinks theres a lot of things wrong with the financial scenario today.

He believes that the government will refuse to accept the responsibility for the mortgage crisis. “Rather than allow the bubble to deflate quickly, it bails out Fannie and Freddie. Mortgage losses build for five years, reaching more than $1 trillion. Housing prices stabilize in good neighborhoods, but risk-averse lending practices result in ghetto-like conditions and widespread vacancy across broad swaths of America. Refusing to substantially raise taxes, annual deficits surpass $1 trillion in 2010. Total government debt begins to spiral out of control as our interest costs mount. Our foreign creditors lose confidence in the dollar and begin dumping it on the world market. Inflation surpasses 20% annually and prices for energy soar. Oil reaches $250 per barrel. The president alleges an international conspiracy to destroy America and threatens to attack China if it continues to sell the dollar. Price controls are instituted. The European press begins referring to Obama as America’s Mugabe!

No paper currency regime has ever lasted. No government in history has ever repaid debts as large as those already assumed by our government (in terms of GDP). A default is not likely – it is inevitable”.

Elsewhere, he also says, “The value of the dollar is going to go down, and the price of everything else is going to go up. I think this sets the stage for a true inflationary crisis – as the economy can’t adjust to soaring commodity prices. I also find it hard to believe our foreign creditors will continue to hold U.S. Treasury bonds if the U.S. Treasury takes on all of the mortgage losses of Fannie Mae and Freddie Mac. I think they’ll dump our bonds and that will literally be the end. No more world reserve currency. No more pegs to the dollar around the world. We’ll be on our way to banana republic status, in terms of credit quality”.

Not a very pleasant scenario. Maybe Porter Stansberry and Jim Rogers are on to something. Jim Rogers has already sold his belongings in the US and moved to China. He’s been heavily short the US financial stocks for a while and is probably celebrating todays crash in the financial stocks. Stansberry also was short FNM & FRE and has often claimed they’re bankrupt and the stocks are going to zero.

So what should you do? I guess you keep shorting the Financials and buy precious metals like Silver and Gold!

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