“Junk stocks” have dramatically outperformed the broad market since the bottom in March. There’s a reason that junk stocks — stocks in which total debt is three, four, or five times the value of equity — have rallied so sharply.

Written off as imminent bankruptcy risks, the market left these types of stocks for dead, assuming that equity value would be wiped out in any balance sheet restructuring scenario. But the credit markets have thawed enough to allow most of these stocks to hang on a little longer, in exchange for refinancing debt at much higher interest rates.

These temporary reprieves from bankruptcy court merited perhaps 100% or even 200% rallies in these stocks. But in the market’s frenzy to assume risk, it has bid up some junk stocks anywhere from 500% to 2,000% from the March lows!

Car rental stocks are classic junk stocks — especially in protracted periods of depressed consumer and business travel. These companies operate with massive debt loads in a brutally competitive, commodity business. They’ve all been cutting employee head count and car fleets at incredible rates in order to stem losses. Yet even in good times, competition is so fierce that car rental companies tend not to return capital to shareholders via dividends (unless they are debt-funded dividends paid to private equity owners — as in the case of Hertz prior to its IPO). These companies also tend to repurchase stock only at peak prices, which destroys per share value.

It’s All About Fleet Management

Over the past few years, car rental companies have transitioned away from having mostly “program cars” in their fleets. Program cars are a convenient way for the likes of GM and Chrysler to sell heavy car volumes in a pinch, but these carmakers must sign agreements to repurchase the sold cars or guarantee a rate of depreciation during a specified period of time. Due to recent financial turmoil of both parties in this arrangement, this doesn’t make as much sense as it used to.

Now the car rental companies are adding mostly “risk cars” to their fleet.

These cars are bought without the security of repurchase agreements, so they will be sold into an uncertain future used car market. This gives car rental companies more control over the length of time they own the vehicles, but it’s transforming their balance sheets into speculations on the health of the used car market. If used car market values soften, then the car rental companies have to either accelerate their depreciation expenses or risk taking capital losses upon disposal. Used car prices have temporarily spiked since April, as demand exceeded temporarily tight supplies.

There are many reasons for this temporary spike in wholesale prices of used cars, but a big one has to do with the fact that “cash for clunkers” needlessly destroyed an estimated 700,000 vehicles that otherwise would have flowed into the supply of used cars. This spike is likely sowing the seeds for a bigger decline in the future values, because it squeezed dealer profit margins to the point that it’s brought financial stress to a huge swathe of regular buyers: small “mom and pop” used car dealers.

Fleet management has a huge impact on earnings, because most car rental companies turn their entire fleets over every 18 or 24 months. This makes the visibility of free cash flow for these highly levered businesses very uncertain.

Nevertheless, like moths to a flame, value investors fly to these stocks after getting burned over and over. They hope that one day these companies will deliver attractive returns in a utopian scenario in which cash flow doesn’t have to be reinvested into the fleet and customers will not flee to lower-priced competitors.

In the real world, we can see from history, car rental companies must constantly reinvest most of the cash flow into refreshing their fleets, servicing debts, and posting collateral for off-balance sheet fleet financing. Also, we know that the Internet prompts more and more consumers to shop for the best possible deal. The Federal Reserve board may appreciate a “welcome” rise in prices for car rentals, but consumers certainly do not; they’ll shop for alternatives in this commodity business if faced with higher prices.

Lower Volumes, Competition, and Debts Are a Recipe for Disaster

All of the car rental stocks were left for dead in early 2009, because it was doubtful whether they could renew the billions in financing commitments for their gargantuan fleets. The car rental business, in my view, is a dinosaur left over from the era of cheap credit and steadily growing business and leisure travel. In the future, we can expect to see an overlevered, capital-intensive set of competitors battling it out for scarce business. This may be good for consumers, but it’s terrible for owners of car rental stocks.

The biggest driver of car rental stock prices during this rally has not been a revival in sales, but rather the hope that because the industry is shedding capacity at a fast rate, pricing power will return. I have my doubts, because once the most-anticipated “V-shaped” economic recovery in history fails to live up to expectations, many rental companies will resort to price cutting to generate cash for newly tightfisted creditors.

Shareholders of these companies are thus left with the claims of the skimpy, infrequent free cash flow that’s left over after the following senior claimants are satisfied: employees, landlords, suppliers of car parts, advertising, insurance, lenders who finance their fleets, and the tax man.

It’s time to bet against these “junkers” and collect serious gains in the process. I’ve already alerted my Strategic Short Report subscribers to what I think is the best way to play these soon-to-fall rental companies (you can learn more by clicking here), but it’s not too late for you to position yourself too.

With more than a half dozen car rental stocks out there, your options are far from limited.

Regards,
Dan Amoss

November 4, 2009

Make 50% By Selling These Junk Stocks Short was originally featured in the Penny Sleuth.

Here’s why the only way to make money in this market is to turn conventional investing strategy on its head…

As cool weather descends upon the Northeast U.S., risk appetites start to wane. Last week, traders and investors finally sobered up. Are they second-guessing whether government spending can actually kick-start a sustainable recovery? Both stocks and corporate bonds sold off sharply.

The big questions of the moment: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: As we see with “cash for clunkers,” government stimuli simply steal demand from the future.

But more importantly — because this is not yet a mainstream view — the real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

So I expect over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are disconnected from reality.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring? The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not — that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it — debased by the Fed’s inflation, of course — back into your other pocket.

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs.

Where you stand on this question will determine your expectations for the future performance of most stocks (ignoring special situations). I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

Some pundits point to corporate mergers and acquisitions as reasons to be bullish, ignoring that fact that most deals occur closer to the peak of markets, and most deals destroy shareholder value, because the buyer overpays. The 2000 AOL-Time Warner merger is a case in point.

Recently announced deals in pursuit of tech service companies are not a sign of strength; they’re defensive moves to counteract declining hardware sales and profit margins. Cisco is constantly adding to its extensive list of acquired technology companies partly to divert the Street’s attention away from the poor growth prospects and rising competition in its core businesses. Dell’s and Xerox’s recently announced acquisitions are defensive because the computer hardware business stinks.

Corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is telling. In a word, the approach toward capital structure is “defensive.”

Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

This isn’t the “buyer’s market” that most of Wall Street would have you believe we’re in.

That doesn’t mean that there isn’t a colossal amount of money to be had in stocks right now – if you’re betting against them. That’s exactly what I’m advising my Strategic Short Report readers to do on a daily basis.

It’s time to turn around your investment analysis and look for companies that are poised to crash, not the ones that could rally in the coming months. Once investor sentiment turns back around, you wont want to be on the long side of most stocks.

Regards,
Dan Amoss

October 8, 2009

The Cold Hard Truth About Economic Recovery was originally featured in the Penny Sleuth.

And that financial malady is now traveling to Main Street as banks – including the latest FDIC rescue operation here in Baltimore on Friday – crumble all around us. Here’s what you need to know to profit from this mess…

The market’s mood can swing between mania and depression over short periods of time, but over longer stretches, stock prices eventually reflect the real value of underlying businesses and whether that value is growing or contracting.

Many stocks will not revisit their lows forged during last fall’s panic, but many others will break to new lows. Right now, the market is positively giddy about the future earnings streams of banks and thrifts and has bid the stocks up in anticipation of a miraculous economic recovery…a recovery that will be weak and limited to few sectors – certainly not including consumer finance, retail, and real estate.

The next move in the financial stocks will be down and regional banks and thrifts will lead this move. As Chris Whalen, a leading authority on the health of the banking sector, notes in the lead quote above: “In bad periods, banks typically set aside twice as much as they charge off, but now a lot of them are at one-to-one.” Most banks are reluctant to book the provision expenses necessary to maintain loss reserves, because this cuts into net income. But delaying recognition doesn’t mean they’ll go away; delay just means that losses in the future could be bigger and exacerbate the trend toward tighter credit. The market for bank stocks is not discounting this development right now, but it will over time. None of these smaller institutions are “too big to fail,” so many will be resolved by the FDIC, and acquired or liquidated.

This month, we’re shooting for 150% gains in put options on a thrift that strayed from its humble roots and is now dangerously undercapitalized.

What we usually do in Strategic Short Report is a form of “time arbitrage.” We recognize that euphoria can push the stocks of capital-destroying companies far above what they’re worth and we take opportunities that the market offers to sell short over a time frame when we expect common sense to prevail and prices to fall. Sentiment toward the financial sector is positively giddy right now, and stock prices have rallied to levels that discount a swift return to happy days and tiny credit losses. But the recession is over, right? No way, if you’re measuring it honestly. And for the banking sector, it’s definitely not over.

Bank Profits Cannot Grow When Balance Sheets Shrink

Now that we’re in a new ice age for the financial sector, many banks will be shrinking their balance sheets. This shrinkage occurs as healthy borrowers pay down debts and are not interested in taking on more debt. With so much excess capacity in so many industries, why should entrepreneurs with good credit look to expand? Especially with the guarantee that if they grow, these entrepreneurs would be, in the eyes of a cash-strapped government, an even juicier source of tax revenue?

This is bad news for banks, because growing private sector demand for credit is the key for banks looking to “earn their way out” of their festering losses.

Such is the paradox of runaway government spending, which is so massive that it’s temporarily boosting GDP figures. But this spending is ultimately self-defeating: The more the government spends, the more the private sector will tap on the brakes. In my view, this is the weak link in Keynesian policies, which Washington, D.C., policymakers keep pursuing aggressively. The federal government is the only notable borrower with growing demand for credit, so lots of banks will wind up buying the bonds of a spendthrift government – hardly the kind of lending that infuses cash into productive private investments and private sector jobs.

This leaves the banking system in a situation in which most borrowers seeking new loans or refinancing are not good credit risks and the borrowers who are good credit risks are not interested in more credit. And let’s not forget the elephant in the room: residential mortgages. This is a problem that cannot be resolved by just refinancing at low rates, or extending terms, because most homeowners with mortgages do not have enough equity to refinance.

The biggest mistake the banking system made was believing that the average value of U.S. houses could never go down. This mistake would have been avoidable with a bit more free market discipline in the banking system, which would have slowed credit flows into mortgage lending once prices had detached from median incomes. It also would have helped if mortgage originators were required to retain a portion of the credit risk involved with each new loan.

Bankers aren’t the only ones to blame. Policymakers made a grave mistake by pursuing the goal of homeownership for everyone. They did not distinguish between homeownership and a “call option on homeownership,” which is a more accurate definition for a low- or no-money down purchase. With the benefit of hindsight, we know that not only did these call options on homeownership expire worthless, but with the smidge of equity gone, the incentive for many homeowners to keep making mortgage payments is also gone.

There are a few more assumptions that fans of bank stocks are ignoring at their own risk. These fans are looking at the experience of the sector during the early 1990s to draw conclusions about the likely trajectory of credit losses, recoveries, and spreads on future lending. They foresee a period of consolidation, followed by a return to the pleasant lending environment.

These bulls are misdiagnosing the situation, and here’s the main reason: The banking system has no experience managing through the current “negative home equity” environment. This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

This problem will cap the upside of bank stocks for years to come, and this sector will offer lots of short selling opportunities.

Regards,
Dan Amoss

August 31, 2009

The Ugly Truth About Bank Stocks was originally featured in the Penny Sleuth.

No one thinks they’re doomed.

I’m talking about the Canadians, of course.

See, lately, I’ve read a lot about the superiority of the Canadian banking system. And naturally, my contrarian instincts prompted a search for a way for you to make money as the Canadian banks go down.

As you may know, an easy way to play the downside of stocks is through put options. Here’s a quick primer on how they work…

Put options are a limited risk, leveraged way for you to make money when stocks drop.

For example — when a stock falls 5% in a day, put options may go up 50%. When big drops happen, puts can go up hundreds of percent in hours.

And since they’re limited risk, if you’re wrong, you’ll never lose more than you put up.

My point is — there’s no easier, safer, and faster way to grab huge gains from downward stocks than through put options.

Having said that, let’s take a look in on how you can use them to make money on the Canadian banks. First, the “macro view…”

The Canadian banking system has won accolades for avoiding direct exposure to the most tempting forbidden fruit: products like subprime mortgages, credit cards, leveraged buyout loans, and loans to finance insane commercial real estate purchases.

The financial press loves Canadian banks. On May 19, The Wall Street Journal ran a piece suggesting that these banks are a model of sustainability, and now have the opportunity to acquire U.S. banks on the cheap:

“Not long ago, Canadian banks were considered slow footed, provincial, and too conservative to flourish in the global boom for financial institutions. Now that banks in the U.S. and Europe are reeling from loan losses and face growing government scrutiny and ownership, Canada’s six major banks are seen as a potential model for battered financial institutions. TD Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada posted more than C$3 billion (US$2.5 billion) in combined profit in the latest quarter.” [Ed. note: quarter ending April 30, 2009.]

Canada’s biggest six banks account for more than 85% of the assets in the country’s banking system. By and large, these banks made a smart decision to avoid securitization. Securitization refers to loans that banks originate, bundle together, and sell off to pension funds, money market funds, insurance companies, and other institutions.

But this doesn’t mean that Canadian banks have no credit risk. On the contrary, they have plenty. Mark to market accounting has not yet cut down Canadian bank earnings, because the Canadians have not yet accounted for the impending wave of mortgage, consumer loan, and corporate loan losses.

They will by the end of 2009. It’s impossible to avoid. And just to give a perspective on how quickly lending grew at the Canadian banks, the chart below shows that assets at the top six Canadian banks grew from C$1.3 trillion in October 1999 to C$2.7 trillion in October 2008. Equity at these top six banks grew in line with assets; all six kept their ratios of assets to common equity fairly constant since 1999.

Growth in assets, even if accompanied by growth in equity, is always a risky proposition for banks. At the time the loans are made, everything seems fine. Then, when a serious recession arrives, and a dramatic credit loss cycle begins, the market value of loan portfolios can rapidly decline by 5% or 10%, pushing the banking system to the edge of insolvency. Insolvency is when the value of assets is less than the value of liabilities. Bank regulators don’t like this scenario and pressure weaker banks to raise very expensive, dilutive equity capital in order to protect more senior lenders, including depositors, from suffering losses.

Canada has just entered what will ultimately be an enormous credit loss cycle, and by the time it’s over, the Canadian banks could easily lose their pristine reputations. Until the middle of 2008, Canada’s economy was booming. Its mining, energy, and manufacturing sectors are world-class, and every other sector was pulled along for the ride.

But the wheels fell off last fall. According to Statistics Canada, the unemployment rate rose to 8.4% in May — the highest in 11 years. Ontario, with its heavy manufacturing base and ties to the “Detroit Three” auto companies, is especially hard hit; Ontario lost 234,000 jobs, or 14% of its entire manufacturing work force, since last October. Ontario will lose even more jobs this summer as GM and Chrysler dramatically cut auto production. Alberta has slowed dramatically too. Just a year ago in Alberta, every skilled construction worker was working overtime on oil sands projects. Now many projects are postponed and workers are getting laid off. The unemployment rate in Alberta nearly doubled from May 2008 to May 2009, to 6.6%, and is heading higher.

For Canada, this credit cycle will probably be worse than the one in the late 1980s. According to RBC Capital Markets, annualized loan loss provisions for the entire Canadian banking system peaked at 2.88% of all loans in 1988. As of April 2009, this figure was just 0.77%. Over the next year or two, loan loss provisions should easily triple or quadruple, which would cut deeply into profits and capital… sending the worst of the Canadian bank stocks down.

So how do you play it?

First, I recommend you dig in to the major banks to figure out the one with the most exposure to unemployment rates. Then, simply visit Yahoo! Finance, enter in their symbol and click on “options” on the top left hand side underneath “Quotes.”

You’ll see all of the put options available on that stock. Pick a good one and you’ll be able to double your money as these stocks go down.

Regards,
Dan Amoss

August 12, 2009

How to Play the Canadian Banking Crisis for a Quick Double was originally featured in the Penny Sleuth.

And I’m going to give you a chance to join them.

If you think Canada escaped the downward trend in U.S. banking, think again. While the country may not have plunged headfirst into subprime mortgages, it did dip heavily into risky derivatives. The leverage it took on generated impressive returns on equity in good times, but that same leverage is set to wipe out equity today.

Shareholders in one “safe” Canadian bank will have to rethink their loyalty. Its looming solvency crisis practically guarantees a dividend cut. And that’s our catalyst for this month’s short play action – offering us a chance for 200% profit potential.

Accounting secrets have not yet obliterated Canadian bank earnings – like those of U.S. banks – because the Canadians have not yet accounted for the coming tsunami of mortgage, consumer loan, and corporate loan losses.

Here’s how they loaded those loan books with hidden risk.

The Basics of Bank Accounting

Bank shareholders leverage their capital by borrowing short-term money, primarily from depositors. Your bank account is an asset for you, but it’s a liability for your bank. For every dollar of capital, bank shareholders borrow 15, 20, or even 30 dollars from senior creditors – otherwise, they could not afford to own their huge portfolios of loans and securities. Here’s the core problem: Bank shareholders and their agents (bank executives) are lending other people’s money. So bankers are looser with lending than if they were lending their own savings.

The accounting process to determine commercial bank profits is inherently speculative, as well. Banks book an upfront profit on every new loan they make, minus a small “provision” for loan losses – just in case some loans wind up going bad. These upfront profits have the habit of disappearing when loans “season,” and banks discover how many deadbeats owe them money. In case you’ve been wondering what has wiped out the majority of the S&P 500’s trailing earnings, here’s your answer: Banks and brokerages reversing most of the profits they booked on loans made and securities bought at the peak of the bubble.

Banks claimed to make good money loans to every borrower. But somebody sure was lying, since they’re taking charges against these older vintage loans and securities left and right. And the industrywide provision for loan losses, which is the single most important – and unpredictable – cost in a bank’s income statement, has been soaring. Once these provision expenses soared on the backs of delinquent loans, the banking sector’s earnings plunged deep into negative territory.

Throw in a few more explosive ingredients like deposit insurance, central bank lending facilities, loan syndication, and securitization and we’re left with a system for which sales volume – not risk management – is priority No. 1.

Those who claim the banking system is well capitalized – including those who designed the unstressful “stress test” – hold rosy assumptions about how many loans will go bad and how much banks will earn from existing loans to have a shot at outrunning their credit losses.

Lots of bank stocks remain in a fragile state. This month, we’re going to buy puts on the Canadian bank most ready to fall. And now’s your chance to join us. If you want the name of my latest play, just click here to learn more about Strategic Short Report.

Regards,
Dan Amoss

August 10, 2009

Don’t Bet on Canada’s Banks was originally featured in the Penny Sleuth.

Yet the stocks of real estate investment trusts (REITs), which are popular among income-oriented retail investors, are still trading at high enough levels that discount just a garden-variety recession in commercial real estate. REITs were designed to invest in portfolios of rental properties, and generally pay no corporate income taxes if they distribute at least 90% of their profits as dividends to their shareholders.

REITs were designed to thrive in an environment of steadily rising property values and rents. But in this ice age for commercial real estate, the REIT business model will cease to function properly; a REIT’s tax-free status doesn’t allow it to retain much excess capital during lean times. Since REITs pay out all their earnings, they cannot grow without taking on more debt. During the boom, a REIT strategy encompassing growth, leverage, and acquisitions was a virtuous cycle that led to juicy dividends and soaring stocks; in this bust, it’s morphed into a vicious cycle of dividend cuts, dilutive equity offerings, debt offerings at double-digit interest rates, and bankruptcies.

The REITs that levered up and grew too fast at the peak will go to zero in bankruptcy. Others could fall into the low single digits by year-end as the market anticipates that creditors will take title to many properties in 2009 and 2010. These developments would push the value of the REIT Index dramatically lower.

$1.6 Trillion in Commercial Real Estate Debt Needs to Be Refinanced

The REIT sector is undercapitalized – just as the big banks were last year. If you mark the value of commercial real estate to market, it tells you that REIT debt in all its forms – commercial mortgages, unsecured notes, secured lines of credit – is much too burdensome. Equity cushions that seemed adequate at the commercial property market peak are now thin. REITs don’t have to mark their assets to market each quarter like investment banks. But you can be sure that before committing a single penny to a secondary offering of REIT stock, institutional investors will mark property portfolios to market.

Marking property to market will result in many underwater commercial properties. This is critically important because the combination of underwater properties (insolvency) and imminent debt maturities (illiquidity) tends to wipe out equity. The maturities over the next five years are staggering, and these debts were sloppily underwritten near the peak of the credit bubble. According to Goldman Sachs research, roughly $1.6 trillion in commercial real estate debt is coming due 2009-2013.

Lenders will not be willing to refinance mortgages in situations where mortgage debt exceeds the value of the property – so-called “underwater” properties. In order for all of these $1.6 trillion in loans to qualify for refinancing, hundreds of billions in new equity will need to be injected into properties. This much new equity capital dedicated to commercial property ownership will not exist in the investing environment of 2009-2013, so many of these loans will default.

In a scenario of paying off staggering debt loads under stress, the claims of common shareholders are either diluted or wiped out completely. This is the scenario facing General Growth Properties, and shareholders will be lucky to recover anything. You can find shades of the General Growth saga throughout the REIT space.

The Credit Markets Are Signaling Danger for REITs

Bulls argue that REIT stocks are cheap enough to buy. After all, they’ve declined to the point that you’d be buying ownership stakes in commercial real estate at prices well below peak values. Also, the high dividend yields already reflect plenty of pessimism.

What is the credit market’s response to REIT bulls? Creditors will take title to many properties in bankruptcy, and dividends will be paid mostly in new shares of REIT stock, rather than cash. I side with the credit markets.

A review of the aggregate REIT balance sheet – and the delusional commercial real estate purchases during the 2006-2007 peak – will tell you that this won’t be a garden-variety bear market in REITs. Supply of retail, office, hotel, and industrial space will greatly exceed demand for several years. In most cases, tenants will have the upper hand in lease renegotiations. This bear market, which is still in its early stages, will go down as the worst REIT bear market in history.

Will the TALF Bail Out REIT Shareholders?

So will the TALF come to the rescue? Wasn’t the Federal Reserve’s “term asset-backed securities loan facility” (TALF) designed in part to mitigate the systemic damage from the time bombs ticking inside of CMBS? A primary reason for the recent rally in REIT shares is hope that the TALF will help restore value to equity of the most-indebted REITs by loosening up lending for commercial mortgages. The Dow Jones U.S. real estate index rallied from an intraday low of 80 in early March to a recent 130 (see chart below). But this REIT rally is based on hope, rather than strong fundamental evidence.

The Fed does not restore equity value to leveraged financial companies sitting on toxic assets; it merely tries to prevent stressed borrowers from unwinding positions too quickly. Look at how little equity value the Fed’s unprecedented lending facilities salvaged for Citigroup shareholders. TALF will do little to preserve equity value for highly indebted REITs. The Fed did not eat the losses on Lehman Bros.’ garbage securities, nor will the Fed or the Treasury eat losses that must be first absorbed by shareholders of overleveraged REITs.

Plus, potential limits on executive pay could limit interest in TALF participation. Special Inspector General Neil Barofsky said in a recently published report that executives involved with the TALF program “could be subject to the executive compensation restrictions.” Whether or not compensation restrictions are enacted as part of TALF, the mere threat of capricious rule changes and taxes imposed by Congress and the administration will scare many potential managers away from TALF.

While there are certainly opportunities to be had in this market, as I see it, REITs aren’t one of them. That said, after the closing bell today, I’m recommending an exciting new play to my Strategic Short Report readers that could generate as much as $200,000 in profits. If you want to be one of the first to act on this opportunity, visit the Strategic Short Report website for more details.

Regards,
Dan Amoss

July 10, 2009

Beware of the REIT Reality was originally featured in the Penny Sleuth.

Many of them have been expanding gas production too quickly until recently, because they were accessing outside capital in the form of debt. But ever since natural gas prices tanked, most have announced that they will “spend within cash flow,” or limit drilling activity to reinvesting the cash flow that they generate.

I’ve spent a lot of time in recent weeks reviewing E&P capital spending plans, and I think the market is underestimating just how quickly U.S. natural gas inventories could contract, given the recent collapse in drilling activity.

The Jan. 23 natural gas inventory report from the EIA revealed a 176 billion cubic foot inventory draw despite severely depressed industrial demand.

E&P companies were financing new drilling projects with debt in 2007 and early 2008, but it did not lead to an inventory glut. This reflects just how intensely the industry needs to drill to meet demand. Now that debt-financed projects are a thing of the past, we can expect to see a significant negative supply response.

For the most part, the E&P industry in the U.S. is very disciplined — perhaps more so than OPEC. E&P companies are responding to the lower natural gas price by slashing drilling and well completion activity in this depressed gas price environment. At $4.50 per thousand cubic feet, the spot price of gas is below marginal cost for most producing fields.

At today’s low prices, it makes economic sense for E&P companies to defer new projects. The U.S. natural gas supply originates from thousands of wells scattered all over the country.

Decline rates of these wells are very steep. Consider that most new production comes from shale plays — where production can decline 70% in the first year after well completion.

So low natural gas production should balance the market later in 2009 — prompting a rebound in natural gas prices. E&P stocks should rebound even faster than gas prices, since they are already discounting years of unattractive prices.

Regards,
Dan Amoss

January 30, 2009

Natural Gas E&P Stocks Should Rebound Quickly was originally featured in the Penny Sleuth.

There are fears that banks will never expand lending again, and that everyone with debt wants to pay it down as fast as possible.

I think these fears are excessive. They ignore the massive and limitless inflation schemes coming from the Treasury and the Fed.

Those fearing deflation assume that every American consumer is stereotypical: an overextended, credit card-addicted, house-flipping gambler. This is simply not the case. Many Americans don’t have a mortgage. And most Americans with mortgages are still making their payments.  They have, however, temporarily reigned in discretionary spending because of falling house and stock prices.

Those fearing deflation also assume that demand for debt is low and falling. But demand for debt doesn’t always come from businesses or households looking to invest more or spend more. Any business or household looking to refinance existing debt at lower rates — and there are many — is a source of demand for new debt. Banks borrowing at the Fed window at 1% or less will be looking to supply this new debt by make highly profitable loans to creditworthy borrowers.

Once borrowers refinance, they may not be as aggressive about spending or expanding business as they used to be. But at least they will have access to credit. In the Great Depression, they did not. So the economy fell into a negative feedback loop of asset sales, bank failures, and rising unemployment.

Treasury and the Fed will keep taking extreme measures to slow down the pace of credit contraction and housing prices — cutting off this deflationary feedback loop. This could include nationalizing Fannie Mae and Freddie Mac and using the Treasury’s low borrowing costs to refinance hundreds of billions in existing mortgage debt into new 40- or 50-year mortgages with reduced principal balances.

Sure, such an action would guarantee a decade or more of stagnation in housing prices, but it will also slow or flatten the rapid decline in prices. This is the essence of the Treasury and Fed actions: to stop the deleveraging from getting out of control — even at the cost of future economic stagnation. Like it or not, I think this is the most likely outcome from this crisis.

If this new debt is too much for savers and foreigners to absorb, I’m sure the Fed would set up an Enron-style conduit to buy up, or “monetize” new Fannie Mae paper.

Remember, Fed Chairman Bernanke believes that the Great Depression and the Japanese deflation grew steadily worse because the government and central banks weren’t radical and decisive enough in their pro-inflation policies.  So there’s every reason to expect radical new inflation policies in the coming months.

Best Regards,
Dan Amoss
November 17, 2008

Rising Inflation: How the Fed’s Pro-Inflation Policies Spell Opportunity was originally featured in the Penny Sleuth.

“Give me control of a nation’s money and I care not who makes her laws.”

— Mayer Amschel Rothschild

Let’s observe a moment of silence to mourn the slow demise of capitalism in the U.S.

Our government is now overtly manipulating the stock market. We have “crossed the Rubicon.” We can no longer pretend to be a free market capitalist country while also maintaining confidence in the U.S. dollar as reserve currency. After this panic subsides, the investing environment will be very different.

Make no mistake about it: The last two weeks will go down as one of the most pivotal periods in financial history. The financial landscape has changed so dramatically that few have had a chance to catch their breath. I’ve spent the entire last week reading and thinking through the free market’s ultimate response to this unprecedented, rapidly changing situation.

Last week, the SEC announced a temporary ban on new short sales in 799 specific financial stocks. We’ve talked about short selling here at Penny Sleuth in the past. It’s one of the most important weapons in an investor’s cache. It allows the market to react to foul play and sloppy corporate leadership. This is an even more important tool to use against poorly run small caps. That’s why this ban is so significant.

Before I go on, let’s first clear something up: This new ban doesn’t mean that existing short positions must be covered. But many are clearly closing short positions to limit risk anyway. The SEC might well have sparked a panic liquidation in other areas of the market, as hedge fund managers liquidate long positions to offset losses on short positions. As I write, the market is well off its highs just one hour into Friday’s trading day. Odds are good that the SEC will realize that its decision only sucked a huge amount of liquidity out of the stock market and reverse its decision to something more sensible, like reinstating the uptick rule.

While on the subject of the SEC’s new short selling rule, allow me to state the obvious: Short sellers did not bring down the investment banks. Once the investment bank executives made the decision to operate their balance sheets like Long-Term Capital Management on steroids, the writing was on the wall. They relied far too much on “quant” models, rather than good old-fashioned common sense.

Rather than target the individuals who had been warning about this situation for years, why doesn’t the SEC investigate the proprietary trades of the banks’ trading desks? I’d expect it would find evidence that the investment banks were short selling each other’s stocks at the same time that they were cutting each other’s lines of credit. In the autopsy of Lehman Brothers’ balance sheet, we have discovered that Lehman management wildly overvalued its toxic assets. Why wasn’t this taken as evidence that the lack of transparency at investment banks is at the root of last week’s crisis?

The SEC’s decision to ban short sales of financial stocks is throwing sand into the markets’ gears. Like most government action, it pays lip service to consequences. Convertible bond traders use short selling to hedge equity risk. After this ban, the price of convertible bonds will probably fall.

Hedge fund managers use short sales to offset the risk in holding long positions. After this ban, fund managers will have to use other means to cut risk, which include selling off huge chunks of their long positions.

Finally, at market bottoms, short sellers provide demand for stocks when they buy to close out short positions. Without this buying pressure, the market could possibly go “no bid” at crucial periods when long investors want to get out at any price.

The SEC would really benefit the market if it cleaned up the system of trade clearing. “Naked short selling” occurs when brokers take orders for short sales and don’t locate the shares to borrow. If a broker cannot locate them, then it shouldn’t tell the short seller that it is able to execute the order. Since the broker doesn’t want to lose the short seller’s business, it probably executes short sales of “hard to borrow” stocks anyway and hopes it can locate the shares in time for settlement.

“Quant funds” — the ones that use computers to trade millions of shares every minute — are lucrative brokerage clients. These funds are most likely to be the ones unknowingly requesting “naked” short sales. The orders come in so fast that it’s hard for the broker to say no, we cannot locate those shares to borrow.

In my view, the SEC can solve the problem of naked short selling with better enforcement of existing rules. Brokers should not be allowed to execute orders to short shares that they have little chance of borrowing. It’s vital that we restore liquidity to our stock market, rather than implement poorly thought-out decisions made overnight.

Best regards,
Dan Amoss, CFA
September 22, 2008

The Short-Selling Ban was originally featured in the Penny Sleuth.

“So when you adjust for all of those things — vintages, CLTV, stated income, where it’s done — that’s what we’re seeing. You know, it’s very early in the loss curves…

“Prime looks terrible, and we’re sorry.”

— J.P. Morgan CEO Jamie Dimon

The recent financial stock rally has all the signs of panicked short covering, rather than typical buying. Consider how the depository institutions most likely to eventually join IndyMac in federal custody — including Washington Mutual, Downey, and Huntington Bancshares — are rallying the most. So many shares had been sold short that a violent rally was inevitable.

Eventually, though, this rally should prompt two things:

1. Mutual funds selling financial stocks into strength. We’ve finally seen a shift in psychology away from buying financials on the dips. Many managers are preparing for an extended bear market in the sector.
2. Banks with capital shortfalls will announce secondary stock offerings. This will lower the cost of new capital, because higher stock prices allow the banks to issue fewer shares to raise a fixed amount of capital.

The SEC is implementing rules that will make it a bit harder to sell short stocks that are difficult to borrow.

I think “naked” short selling (shorting a stock when your broker has not yet located shares to short) must be stopped. This practice gives legitimate short selling a bad name.

Stock should be located and borrowed before it is sold short, not the other way around. If your broker cannot locate shares to short, you should move on to another idea, or use put options.

But the hysteria about “rumors” bringing down financial companies has gone too far, I think. This is the defense of CEOs who are looking to blame someone for their own incompetence — incompetence that put their firms in a vulnerable position in the first place. Short sellers did not conspire to force Wall Street firms to enter the business of securitizing dodgy debts. Firms like Bear Stearns ruined their own companies with the poor strategic decisions they made. The free flow of opinions is vital for the health of the stock market. One should be very suspicious about executives who try to suppress any negative opinions about the value of their stock. Allied Capital comes to mind.

You can read about Allied’s crusade against David Einhorn in his excellent book, Fooling Some of the People All of the Time.

Allied is still a good short idea looking out beyond a year because it’s running out of attractive assets to sell and finding it harder and harder to issue new equity.

Short sellers need to do their own fundamental research and form their own opinions. Only fools buy or sell short stocks based solely on rumors. Legitimate short sellers are very beneficial for the market. They provide liquidity at market bottoms by buying to cover their positions, and they are often the first to discover and put an end to accounting frauds and stock promotion schemes that siphon capital away from legitimate businesses.

Timing is important in the banking business. Also, as in investing, it pays to be a smart contrarian. Ideally, banks should make as many loans as possible once the economy bottoms. In an improving economy, borrowers can more easily pay down debts.

Loans made with disciplined underwriting guidelines ahead of an economic boom can be both safe and profitable.

On the other hand, aggressively expanding a loan book at the peak of a credit cycle and an economic cycle can lead to disaster.

Once credit cycles turn, loan portfolios, or loan books, become sources of risk, rather than profit. Look at the experience of Countrywide, which just got acquired by Bank of America for a fraction of is peak value. It blew itself up by aggressively expanding its mortgage loan book at the peak of the credit cycle — which happened to coincide with the biggest housing bubble in history.

Regards,
Dan Amoss, CFA
August 27, 2008

The Next Victim in the Banking Fiasco was originally featured in the Penny Sleuth.