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What I Learned at the Best Investment Conference of My Life

By Dan Ferris, editor, Extreme Value
Saturday, May 16, 2009

Just over a week ago, I attended the best investment conference of my life... the 2009 Value Investing Congress in Pasadena, California. 

One of the top presentations I saw was Whitney Tilson's detailed update on the credit crisis. He and his partner, Glenn Tongue, have written a book called More Mortgage Meltdown. It covers the history of the credit crisis, including their latest update, and provides six investment ideas based on their credit-market research. 

The long stock picks include Berkshire Hathaway, Wells Fargo, and American Express. I'll let you peruse the book for the others. It's the No. 1 resource for understanding the mortgage bubble. I highly recommend it. 

Here's the short version of the current situation: It gets much worse before it gets better. The book provides full details on several problem areas in the mortgage market: subprime, Alt-A, jumbo prime... and option ARMs. 

Option ARMs give you three payment options. You can make the regular payment, which covers interest and reduces principal. You can make the interest-only payment, which doesn't reduce principal. Or you can do what 80% of option-ARM borrowers do: Take the third option, the minimum payment, which doesn't even cover interest. That option adds the unpaid interest to the principal, causing the principal to rise (so-called "negative amortization"). 

The authors say option ARMs are "toxic in so many ways it's hard to know where to begin." About $749 billion of option ARMs were written from 2004 to 2007. Relatively little refinancing has taken place, and over $600 billion option ARMs are still outstanding. Most of these loans will default. The delinquency rate is already above 30%. The 2006 vintage has a default rate higher than 40%, the minimum Tilson and Tongue expect for total option ARM losses. 

Back in April 2008, I told readers I expected over $1 trillion of mortgage losses. Since the mortgage bubble started popping, approximately $1.1 trillion of writedowns have been taken. The authors estimate that's not even one-third of the $3.8 trillion of total losses they think will occur across all mortgage types. So there's more than twice as much pain ahead as behind. Ouch. 

One of the speakers in Pasadena, Igor Lotsvin of Soma Asset Management, said banks are a proxy for the credit markets. In other words, the mortgage crisis will be even harder on banks in the next couple of years than in the last couple. Banks with large exposure to home-equity, commercial real estate, option ARM, and construction loans will suffer writedowns. Many will fail. Jason Stock and Bill Waller from M3 Funds predict more than 150 bank failures in 2009. So far, 32 banks have failed since January 1, more than the 25 that failed in all of 2008. 

Think about this: Subprime lit the fuse and started the mortgage meltdown. The total amount of subprime loans back in April 2008 was about $1.3 trillion... Well, the commercial mortgage market now, at about $3.5 trillion, is three times the size of the subprime market then. Outstanding Alt-A loans, another problem area, total more than $2 trillion. Don't for one minute let anyone anywhere tell you this thing is even half over. I know I've said it already, but it bears repeating: The worst is yet to come

As crazy as it sounds, this is fantastic news for long-term investors. The housing and credit crisis has created so much pessimism that world-class businesses like Procter & Gamble and Berkshire Hathaway are selling for values I thought I'd never see. You only get these businesses on sale when things get terrible for a few years. 

Expect things to get worse in the real estate market. Make sure you own gold bullion as a crisis hedge against it. And take advantage of this opportunity to fill your portfolio with the world's best businesses. 

Good investing, 

Dan Ferris 

P.S. You can learn my short list of World Dominating businesses with a subscription to Extreme Value. Click here to learn more. You can also learn read my recent DailyWealth essays on this idea here and here

Market Notes


Our chart of the week is a micro version of Thursday's "most important chart in the world."

Thursday's chart displayed the fresh nine-month high in GDX, the gold stock ETF. This is a critical breakout for our "inflation hound." Gold stocks rise when government money printing spooks investors.

GDX is full of the biggest and best gold miners in the world. But what about the small gold stocks... the tiny resource producers that can soar thousands of percent when inflation kicks up?

Our chart shows the past two years in the "Dow Industrials of small resource stocks"... the Toronto Venture Exchange Index. As you can see, tiny resource companies took a beating in 2008. But like large-cap miners, these companies are in a beautiful new uptrend. Stay long small miners...

– Brian Hunt

In The Daily Crux

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