The knot... The AAA scam... When the sheikh blinks... Still scared on Wall Street... Icahn's blog... "I'm telling the SEC"...

Talk about a knot.

A few years back, bankers decided to abandon their fiduciary responsibilities as lenders, in order to make more loans (and earn bigger bonuses). How? They began selling the loans they made to other investors. Why in the world would you buy a loan made by someone else, using dubious credit standards? Because the loan is insured! And how could loans like these be insured? Because they were rated AAA. And why were they rated AAA? Because prices for homes in America almost never decline...

As long as nobody asked too many questions (and as long as too many people didn't default), the whole scam worked wonderfully. Mortgages were plentiful, housing prices went up. Wall Street made a fortune selling billions and billions in bonds – mostly to our foreign creditors. And our political leaders patted themselves on the back for delivering such a robust economy on the heels of 9/11 – and for making "home ownership" affordable for literally anyone.

Of course, the whole idea was nothing more than a scam. You cannot turn a zero-down-payment mortgage made on a house in a bad neighborhood to a borrower with a bad credit score into a AAA-rated security – no matter how many ways you slice it. As should have been obvious to any thinking person, an entire nation cannot create lasting prosperity built on debt. (See "Generation Debt," my series of essays written back in 2002, at the start of all this...)

Now the game is coming unraveled. This crisis is like an old sweater... If you keep pulling on the string long enough, the whole thing will disappear. But if you stop pulling too soon, it'll come loose again. Should we have bailed out "homeowners" (who never really owned anything) so that they could pay their mortgages? No... we couldn't afford to do that. Should we bail out the banks, so they can lend again? (The oil sheikhs are trying... but the total owed might come to several hundred billion dollars. Sooner or later, they'll blink.) Should the banks be forced to bail out the mortgage-insurance companies, so they can afford to cover the losses on the bonds the banks created in the first place? That's what they're trying now.

Meanwhile, Fitch Ratings placed MBIA's AAA-credit rating back under review for a downgrade after affirming the rating last month. Fitch now says the world's largest bond insurer may not have sufficient capital to maintain its rating, despite raising $1.5 billion in the past two months. Only one institution in the world has enough money to staunch these wounds – the Fed. Should the Federal Reserve print up enough money to paper over the whole debacle? They're doing their best.

I know what will happen, dear subscriber. The feckless bankers will be bailed out, by hook or crook. Irresponsible borrowers will demand the right to keep their homes (which they've never actually owned). And the resulting inflation will be blamed on "ruthless" speculators and "greedy" hoarders – whose businesses and property will then become the subject of "windfall" taxation.

Nobody asked me what should be done. But I'll offer an opinion, regardless. When faced with the almost limitless complexity of such a situation, I remember a few simple, traditional principles. Like something my father taught me very early in life: There is no such thing as a free lunch. And you must take responsibility for your actions.

Banks that made fraudulent loans should be forced to cover the resulting losses. Borrowers who can't make their payments ought to lose their homes. Insurance companies who owe claims on policies should pay up or else go out of business. There is no other way to figure out how all of these pieces ought to fit back together. Letting the market "clear" through falling prices, bankruptcy, and auction is both the fastest and the only morally sound way to solve this problem. Of course, you can bet this solution will only come about after all the other ways have tried and failed. And, sadly, it is our currency that will bear the brunt of this folly, making a lie out of one of the other things my father taught me: A penny saved is a penny earned.

The smart money sees this all coming down the pike... U.S. credit markets are trading "like we're in the middle of the worst recession we've seen in a very, very long time. There is a lot of liquidity out there, but people are very hesitant to use it... fear has overwhelmed greed." This according to David Viniar, CFO of Goldman Sachs.

The markets can rule out a Warren Buffett-led rescue of bond insurers... "We could have some kind of insurance transaction with them but we will not be investing in them or any other bond insurer," Buffett said recently. "We've got our own bond insurer. Berkshire Hathaway Assurance is already up and running in New York State and has already done a couple of deals."

While Buffett is busy ensuring the success of his new insurance business, fellow billionaire Carl Icahn will be writing his new blog, The Icahn Report. The corporate raider told Reuters, "This country is losing its economic hegemony... I want to see who is interested in this. I really think there's a lot to do." Icahn won't discuss investment ideas or companies he owns on the blog. Instead, he's focusing on corporate governance. Check it out here...

Good news for those of you in the market for $10 million+ homes. Foreclosures are hitting the Hamptons – the beachy playground for Manhattan's ultra-wealthy. A $15 million beach home in East Hampton went into the early stages of foreclosure last month due to delinquent payments. The owner paid his outstanding balance, beating back the creditors for now. Currently 40 homes are in various stages of foreclosure in East Hampton and another 40 in Southampton.

Finally, a personal note. I've suffered a terrible tragedy this week. Since early 2003, I have been a user of Google's Gmail service. (I was one of the early beta testers...) Gmail has always worked for me – no problems. And so for the last five years, I've kept every single e-mail on Gmail's servers, accessing my e-mail from anywhere in the world. But... on Monday morning... my password suddenly stopped working. And my back-up secret question has failed, too. Even the secondary e-mail I'd linked to my Gmail account appears to have been changed. Did someone "hack" into my Gmail account? I don't know... I only know I've apparently lost the last five years of my business and personal correspondence. I'm devastated. If you know anyone at Google who can help me, please ask them to get in touch.

New high: Annaly Capital (NLY).

In the mailbag... A subscriber threatens to tell on me. And many others doubt the validity of a risk-management strategy I've discovered. Tell us what you think: feedback@stansberryresearch.com.

"I have had your newsletters off and on for a few years. Though the $99 ones, as I can't afford your niche opportunities. Currently I have your oil and medical newsletters and I enjoy the thorough research and financial insights. I did invest in a few stocks but one particular was ELN in 2003 when the stock was still low and bought at under $6. I have sold parcels since in the $22s and recently in the $24s and still sitting on a lot. I would never have known about the company if I didn't subscribe to your newsletter. When I sold in the $22s, it was due to needing cash only a few months later did it shoot up to $30s.

"I keep many recommendations on a watch list. I have limited investment money so I choose as wisely as one can. I have had losses like anyone else, but the ELN stock has kept me in the black and pared all loses to date. So I thank you very much." – Paid-up subscriber Kevin R.

"Hey guys, thanks for steering me in the right direction with DBA, NLY, and MFA all are up since I first got in, even when most are tanking! You Rock!" – Paid-up subscriber Allen Nichols

"Come on guys do the right thing and admit your mistake..I can't believe you are not notifying your subscribers of the error..I have lost all respect for your publication and it lacks creditability...I see you are now tweaking the message....If I don't see a retraction ASAP to your subscribers then I'm going to notify the SEC of false advertising...

"I'm amazed how many times I noticed flaw analysis in your newsletters I don't always write too busy...Anyway the latest one is regarding the Feb recommendation from PSIA, it proclaims it is a no risk invest can't loss $$ well right away you know that is very unlikely...' This strategy eliminates all of the downside risk of buying stocks. Not some of the risk – all of the risk. Using this simple technique, you can arrange your portfolio so it will be impossible for you to lose another penny, ever, in stocks.' What a joke and it is so obvious that you can loss $$ to make this statement is embarrassing and you would have to be an idiot to believe it...I expect better from Porter. This is not what I call eliminating all the downside risk !!!!!!  How can you get it so wrong??" – Paid-up subscriber Robert Montesione

Porter comment: Well... first of all... you've already paid to receive my newsletter – it's not advertising. If you don't like what I've written, just ask us for your money back and "change the channel." Secondly, if it were advertising and it were false, you'd want to tattle on me to the Federal Trade Commission, not the SEC. We've published a newsletter, not sold you a security. And finally, I've written nothing that's not absolutely correct.

What I wrote in my letter (if you'll take the time to actually read it) is that, from time to time, you can find situations where the entire cost of an at-the-money put option can be financed by the dividends you'll receive from the stock you want to invest in. As I pointed out in my letter, this was true (at the time) for shares of Bank of America, whose 6% dividend would have financed the entire cost of an at-the-money put. As a result, if you'd bought the stock, the dividends over three years would reimburse you for the cost of the put, making it impossible for you to lose any money – assuming Bank of America didn't cut its dividend. And, as people who actually read my letter know, I decided not to recommend this packaged trade because I'm not confident that the dividend won't be cut. In fact, I think the dividend will be cut.

Instead, I recommended another similar situation, where the stock price is around the strike price of the put and where the put is around the total you're likely to receive from three years of dividends. I was very clear in my letter that this would only protect your capital if the stock price fell below $15. Depending on how much you pay for the put and when you buy the stock, you will be risking around $2 currently in this trade. That's about 12% of the share price. And considering that a "sum of the parts" analysis puts the share price around $40, that's a tremendously good investment to make. You're risking 12% on a reasonable opportunity to make 300%.

As my fellow analyst Tom Dyson said (after he actually read my newsletter): "Great newsletter, Poor-Tah. You got me fired up about this idea and I want to invest money in it. The baby was crying while I was reading the beginning of this letter, and I still couldn't tear myself away..."

Regards,

Porter Stansberry
Baltimore, Maryland
February 6, 2008

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