Last Legs of the Sucker's Rally

The Bernanke Put and the Last Legs of the Stock Market Sucker's Rally

By Nouriel Roubini | 30 November 2007

How sharply will the US stock market fall if the US experiences a recession? Given the recent flow of very negative macro news, the likelihood of a US hard landing has sharply increased; thus, it is important to assess the implication of such a growth slowdown, hard landing or outright recession on the stock market.

It is true that in the last two days the US stock market has recovered sharply after a significant 10% downward correction in the period from early October until Monday. But the most sensible interpretation of the upward move on Tuesday and Wednesday this week (in spite of an onslaught of lousy macro news: consumer confidence, existing home sales, Beige Book, fall in durable goods orders, regional Fed manufacturing reports, initial claims for unemployment benefits, expectations that Q4 growth will be closer to 0% after the revised 4.9% in Q3, sharply rising credit losses, falling home prices and a worsening housing recession, etc.) is that this is the last leg of a sucker rally (or dead cat bounce) driven by wishful hopes that the Fed easing will prevent a recession.

Certainly on Wednesday, the equities rally was totally driven by Fed governor Kohn signaling the obvious, i.e. that given that the liquidity and credit crunch is now worse than at its August peak the Fed will cut rates in December, January and for as long as needed. In this game of chicken between the Fed and the bond market (with the latter signaling already for a while that the Fed will keep on cutting) the Fed was obviously the one to blink: this was no surprise to anyone who had noticed the meltdown in financial markets (an ugly liquidity and credit crunch) in the last few weeks. But for some reason the stock market only discovered on Wednesday what analysts, the bond market and credit markets had known all along— that the Fed will have to keep on cutting rates as we are headed towards an ugly recession that is now inevitable regardless of how much the Fed cuts rates.

The behaviour of the stock market since last August can be best interpreted in terms of a Bernanke Put, i.e., the stock markets' hope that a Fed easing will prevent a hard landing of the economy. The August liquidity and credit shock severely tested the stock market downward; then you had a first sucker rally on August 16th when the Fed announced the switch from a tightening bias towards an easing bias. A second phase of this sucker rally occurred on September 18th when the Fed surprised the markets with a 50bps Fed Funds rate cut rather than the 25bps that the market expected. Then equities kept on rising, in spite of worsening economic and credit news, all the way until October 9th. Then, a drumbeat of weaker and weaker economic and credit news started to take a toll again on the stock market and triggered the beginning of the stock market correction (10% fall in stock prices) that continued until last Monday November 26th. A third phase of this sucker rally occured after the Fed cut rates on October 31st triggering another stock market rally that turned out to be brief as a bombardment of awful credit news and weak economic data pushed down the market again.

The current leg of the sucker rally started Wednesday— with stock prices sharply up— when Kohn effectively signaled to the markets that— in spite of all the Fed rhetoric to the contrary in the last few weeks— the Fed would ease rates in December and for as long as needed to deal with the liquidity and credit crunch and to avoid a recession. In each case in the last few months the stock market has rallied when the Fed has signaled a willingness to ease monetary policy to avoid a recession.

Call it a Bernanke Put if you believe that the Fed is trying to avoid a financial meltdwon; call it a need to bail out the economy rather than bailing out the markets if you believe— as I do— that the Fed actions are more driven by its concerns about the economy rather than an attempt to rescue investors; call it a moral hazard play if you believe that the Fed is trying to rescue investors and risks creating still another asset bubble down the line. You can call it whatever you like, but one thing is obvious: the Fed easing is perceived by the stock market as an action aimed to prevent a recession from occurring and stock prices rally— in spite of worsening macroeconomic news that signals a recession ahead— because of the hope— that I will show is only a hope— that the Fed will be able to avoid a hard landing. Thus, what has been mostly driving up the stock market in the cycles since last summer is expectations of easing Fed policy. The same pattern of market delusion and serial sucker rallies occurred in 2001: the economy entered in a recession in March 2001 but the S&P 500 index rallied by a whopping 18% in April and May because the market and investors expected that the aggressive Fed easing— that had started in January— would prevent a 2001 recession (the famed and deluded hope of a second half of 2001 "growth rebound" that never occurred). It was only in June when it was obvious that the economy was still sinking in spite of the Fed's hold on rates [[but not until after a final coup de grâce of 50bpts! : normxxx]] that the stock market started to sharply fall again; so then and again now the onset of a recession led to a typical sucker rally fed by expectations of a Fed bailout of the economy; and the latest rally this week is occurring while the liquidity crunch and credit crunch in the markets are as bad now or worse than in August and while the news is worsening by the day. Indeed the 2008 recession will repeat the Fed cycle and stock market cycle of the 2000 - 2001 recession: then the Fed tightened rates all the way to 6.5% in June 2000 and kept a tightening bias in July, September, November as it was worried more about inflation than about growth (that had been as strong as 5% in Q2 of 2000 but was sharply deceleraring by H2 of 2000 as the tech boom went bust). The Fed was totally mistaken then about its assessment of the effects of the tech bust on the economy and kept on worrying about inflation while growth was plunging after Q2 of 2000; it was only at the mid December 2000 FOMC meeting, when the signals were that the holiday sales would be awful, that the Fed suddenly switched from its November FOMC tightening bias to an easing bias. And two weeks later when, after lousy holiday sales data, the NASDAQ fell 7% on its first 2001 trading day of January, the Fed started to cut the Fed Funds rate aggressively with a an initial 50bps inter-meeting cut that day. Then as now, you had a sucker rally following the Fed easings that intensified in April and May 2001 as the Fed kept cutting rates. Indeed, not only the Fed got it wrong on the coming recession in the 2000 - 2001 period; but the professional forecasters also got it wrong, as an Economist magazine poll in March 2001 (when the recession had already started) showed that 95% of the forecasters believed that a recession would be avoided as the aggressive Fed easing would lead to a H2 growth rebound. And, as discussed above, even the stock market got it wrong as the 18% final sucker rally (or last dead cat bounce) in April and May 2001 was followed by a massive bear market starting in June 2001 as the economy spun down into a deeper recession in spite of the aggressive Fed ease.

To take a longer and more analytical perspective, notice that typically a sucker rally occurs at the beginning of an economic slowdown that leads to recession. The initial reaction of markets to a flow of bad economic news is usually a stock market rally based on the belief that a Fed pause (like the rally following the August 2006 Fed pause) and then possibly easing will rescue the economy. This rally always ends up being a sucker rally as, over time, the anticipated beneficial effects of a Fed ease meet the reality of the investors realization that a recession is coming and that the effects of such a recession on profits and earnings are first order, while the effects of the Fed easing on the economy and stock market are— in the short run of a recession— only second order.

That is why we have had several sucker rallies this fall— every time the Fed eased rates or surprised markets with greater easing than expected or signaled to markets that it would ease ahead (as on Wednesday). But, as the continued flow of poor economic news increases the general expectation of a looming recession, the equity markets will— in due course— fall sharply when the successive waves of negative news and macro developments hits an already weakened and vulnerable economy hard; then you will see a serious bear market in equities. So, equities came under great pressure in July and August when the credit market very nearly froze and the financial news turned very negative; they rallied only after the August 16th and September 18th Fed surprises; and turned into a negative 10% after October 9th when the news became awful again.

It is well known— from basic macroeconomic theory— that the equity market reaction to poor growth news is ambiguous. Lower than expected growth leads to a higher stock market value via the "lower interest rate expectation channel" and to a lower stock market value via the "lower profits/earnings expectation channel". The former effect derives from the fact that bad economic news increase the probability that the Fed will ease monetary policy and thus stimulate the economy, demand and profits. The latter channel derives from the fact that slower growth— or even worse an outright recession— will lead to lower demand, lower revenues and lower profits. Indeed, as stock prices are forward looking, and nominally equal to the discounted value of dividends where the discount rate is related to an appropriate measure of interest rates, bad growth news affects both the numerator and denominator (both are expected to decrease) of the ratio of dividends to the appropriate discount rate. Usually, the first effect (the denominator) dominates at the beginning of an economic slowdown— when the likelihood of a slowdown is high but the likelihood of a true hard landing or recession is still low and unclear: then the interest rate channel dominates the profits channel. But once the signal of a hard landing or recession become clearer and the likelihood of such hard landing sufficiently high, the profits channel (the numerator) dominates the interest rate channel.

Why is this conceptual discussion important? Now that the likelihood of a recession has increased— even in the eyes of otherwise soft landing analysts— one is starting to hear and read with increasing frequency such Goldilocks statements such as "a hard landing will be good for stocks" or "the stock market can rally during a recession" or "the Fed will most certainly rescue the markets if there is a recessionary hard landing" or "P/E ratios are low and earnings yields are much higher than bond yields, thus the stock market is now undervalued".

[ Normxxx Here:  That last is the result of the infamous "Fed model" which, as John Hussman has pointed out, "... has nearly insane implications. For example, the model implies that stocks were not even 20% undervalued at the generational 1982 lows, when the P/E on the S&P 500 was less than 7. Stocks followed with 20% annual returns, not just for one year, not just for 10 years, but for 18 years. Interestingly, the Fed Model also identifies the market as about 20% undervalued in 1972, just before the S&P 500 fell by half. And though it's not depicted in the above chart, if you go back even further in history, you'll find that the Fed Model implies that stocks were about as “undervalued” as it says stocks are today— right before the 1929 crash."  ]

To clear the air from the spin that one is increasingly hearing, it is useful to ask a simple factual question: what is the relation between stock markets and recessions? So, for a moment, let us leave aside the issue of whether my recession call is correct or not. But let us assume, for the sake of argument, that a recession is coming and then ask the question: if we have a recession, what will happen to the stock market? So, you don't have to believe in a recessionary hard landing to consider this specific question. You just need to ask yourself— what happens to stock prices when recessions do come.

Luckily we have enough data from previous recessions and stock prices to give an answer to this question. Consider the charts below. They present the percentage change in that S&P500 index around the time of the last six U.S. recessions (i.e. starting with 1970)— in the months before the start of a recession, in the months during a recession, and in the months after it. The vertical lines in each chart represents the peak of the business cycle (the beginning of a recession) and its trough (end of a recession). On average the stock market does not change much between the peak and the trough of the business cycle: on average the fall is only 0.4% between peak and trough; in some recessions— such as the 1974 - 1975 one— the peak-to-trough fall is fairly deep (-13%), but in others— such as the 1980 one— stock prices actually rose 5.8% between peak and trough. So 0.4% is an average for all recessions, but scarcely captures the variability.

This may seem like a relatively small market change, but the peak-to-trough comparison is deceptive. It is deceptive because, usually, the stock market starts to fall apart well before a recession starts (even before the business cycle/boom peaks), then falls very sharply during the first stage of a recession, and finally starts to recover in the late stages of a recession (even before the business cycle/recession has reached its trough). Specifically, the stock market fall from the peak of a business cycle to the nadir of the business cycle averages 17.5%; and in every one of these six recessions you have the same pattern: initially stock prices fall sharply before the economy enters recession. Then, the recovery of the stock market starts before the trough of the business cycle— before the economy has begun recovering from the recession.

[ Normxxx Here:  FWIW, this may be somewhat deceptive. Economic indicators lag almost as badly as economists— just about every economist will admit to a recession once it is well apparent that we are in one. The market is probably just much more sensitive to economic conditions than most indicators (and economists). Which is not to say it (alone) is more accurate; everyone is familiar with that old saw, "the market has predicted nine of the past six recessions!"  ]

Note again that, in most episodes, the stock market peaks a few months before the formal peak of the business cycle and starts falling before the onset the recession. Therefore, the average fall of the stock market from its business cycle peak to its business cycle low is well above 17.5%. In fact, this average fall in stock prices from its just pre-recession peak to its near end of recession bottom is actually close to 28%, an extremely severe fall.

So we can see that the peak-to-trough, almost flat, average behavior of the stock market conceals a much sharper fall over the course of a recessionary episode (starting just before the peak of the prior boom cycle), followed by an equally sharp recovery in the late stages of the recession. This pattern makes sense, as equity prices are forward looking and tend to reflect all imnmediately available information about the expected path of earnings, dividends, and interest rates. The stock market starts to fall early because the closer you get to the peak of the business cycle, the higher is the probability that a recession will occur and will thus drag down profits [[actually, I would maintain that, the closer to the peak, the more the financial/economic conditions that have contributed to that peak have (relatively) deteriorated; therefore, the market does not have to be prescient: normxxx]]. So, a 'forward looking' equity market peaks before the peak of the business cycle and starts falling before the actual recession has started. That is why stock prices tend to be a good— if imperfect— leading indicator of the business cycle end [[and explains why the market alone often fails as an indicator, since the conditions it is 'seeing' may recover short of a recession: normxxx]].

The fall in the stock market from its peak of the business cycle to its lowest level in the following recession was 21.0% in the 1970 recession, 33.88% in the 1974 - 75 recession, 10.6% in the 1980 recession, 18.2% in the 1981 - 82 recession, 14.6% in the 1990 recession, and 10.3% [[[sic] I believe it was actually 38% from peak to trough for the Dow and 46% for the S&P: normxxx]] in the 2001 recession. In 1970, the stock market peaked 9 months before the recession and fell 12% before the recession started. In 1973 - 75, the market peaked 12 months before the start of the recession and fell 23% before the recession formally started in December 1973, with a good half of this pre-recession drop right after the beginning of the Yom Kippur war that led to Arab oil embargo. One exception is 1980 when the stock market actually rose in the months just before the start of the recession in February. In 1981 - 82, the stock market peaked four months before the onset of the recession and then fell about 4% before the recession actually started. In 1990, the stock market peaked two month before the recession and fell about 2% before the start of the recession. In the 2001 episode, the S&P peaked about seven months before the start of the recession in March 2001 and then fell by 31% before the recession started. (The peak of the Nasdaq was even earlier, in March 2000 a full year before the onset of the recession.)

Of course, in the last few decades, sometimes U.S. stock prices have fallen and a recession has not materialized— stock markets are not a perfect and always correct leading indicator of a recession. But, and this is most important in the context of the question asked above, almost every time a recession did occur, the stock market fell sharply [[only one false negative! : normxxx]]. The issue is not whether the stock market has at times provided incorrect signals of the business cycle; rather, the issue is whether a hard landing and the onsets of recessions are associated with sharply falling stock prices. And the simple and unequivocal answer is that recessions lead to very bearish stock markets where from the peak in the economy to the trough in the stock market the fall is about 17.5%, whereas the peak-to-trough in the stock market (i.e. the pre-recession market peak to the near end of recession market botttom) is about 28%. So, hard landings and recessions do lead to bear stock markets, but the markets usually provide an early warning. The recent market buzz and chatter about hard landings and recessions "being good for the stock market" is counter-factual and utter nonsense based on the historical data.

The fact that the stock market begins recovery before the trough of the business cycle is reach is also logical and based on the forward looking nature of stock prices: even before a recession has ended the rate of the fall in economic activity tends to decrease markedly. (In the early stage of a recession, the first derivative of output is negative, indicating negative growth, while the second derivative shows an acceleration of the rate of economic contraction. In the late stage of a recession, the first derivative is still negative but the second derivative shows a deceleration of the rate at which the economy is contracting and signals that the trough of the business cycle may be close. Thus, it is not necessary to wait until the recession is over for stock prices to anticipate better earnings and dividends.

How about "soft landing" episodes, i.e. episode where a Fed tightening did not lead to an outright recession but rather to a significant slowdown of the economy and then an economic recovery? The only recent episode of a successful soft landing is 1994 - 95 when a 300bps tightening by the Fed in 1994 led to a relatively sharp slowdown in the economy. But even in that episode, the Fed risked overdoing it and eased the rate in 1995 only when the slowdown in the economy already appeared as excessive. Note that, in that episode, the economy was just recovering from a painful recession that, while formally ended in 1991, was still followed by job-loss and a very slow job (the famous "job-less") recovery of 1992 and 1993. Only by early 1994 was the economy showing signs of healthy growth and employment recovery.

So the monetary tightening of 1994 - 95 was bound to be a lot more tentative on the part of the Fed (and the business cycle was at a much healthier stage)— the Fed was largely bringing the Fed Funds rate back to a more 'neutral' level (if rather abruptly) after its sharp easing during the 1990 - 91 recession. In terms of the market consequences of such a "soft landing", the S&P500 fell by 5% between January and December 1994 as the Fed tightening was under way and the economy was starting to decelerate. Thus, while the S&P had started to recover briskly after the 1990 - 91 recession, and had double digit returns both in 1992 and 1993 (and subsequently from 1995 on), the "soft landing" of the economy in 1994 led to a significant fall in the stock market. The underlying trend in the market index of the double digit annual recovery in 1992, 1993, and after 1995, implied an underperformance of the stock market relative to trend was of the order of 17%, i.e., without the soft landing slowdown of 1994 the market could have grown— based on the underlying trend of the S&P— by a further 17%.

What are the potential caveats to the arguments above that a US recession would lead to a sharp drop in the stock market? Some argue that the sharp fall in equity prices during previous recessions occurred after long periods in which the market was bullish and sharply increasing; thus, close to the recession P/E ratios were already excessively high and bound to adjust; also the monetary and credit tightening in previous recessions squeezed profits severely and pushed equity prices lower.

Today, it is argued that conditions are very different from such previous growth slowdowns: equity prices zig-zagged without much of a strong trend from 2002 to 2005 and have grown only 'modestly' since, while earnings have sharply increased. Thus, the argument goes, P/E ratios are now relatively low and valuations are not inflated [[moreover, by historical standards, monetary policy is 'easy'— and preparing to ease further: normxxx]]. If anything, given the surge in earnings valuations, the ratios are relative low and bound to rise if a "soft landing" occurs, or not fall much even if a "hard landing" does occur. Specifically, unless a major credit crunch leads to a sharp fall in profits and earnings, equity valuations may not be as much at risk in a US hard landing scenario.

[ Normxxx Here:  Two caveats to the caveats. One, P/E ratios always tend to rise during a recession as earnings fall (but rarely enough to offset the falling earnings). P/E ratios tend to be lowest at the peak of the earnings cycle and highest at the bottom of the earnings cycle— as is only logical; investors are not entirely fools and always anticipate some diminution of earnings (if not a recession) at the top and and an (eventual) recovery in earnings (some day) at the bottom. Two, the 'caveat commentators' are obviously unfamiliar with the thirty-year secular cycle in average P/E ratios. According to that cycle, average P/E ratios are scheduled to fall further until about 2010.  ]

The above arguments require a whole separate discussion of earnings and profits and their likely future trends that will be discussed in another note. For now, let us observe why these arguments are not convincing. First, in a recession, revenues fall and both profits and earnings sharply fall; so equity valuations need to take a hit; and while recessions triggered by a credit crunch or a monetary tightening have more severe effects on corporate profits, even recessions triggered by the bursting of a bubble— the tech bubble in 2000, the housing bubble today and its consequent credit crunch— can severely affect earnings and thus valuations. In a typical US recession NIPA profits fall by about 20% and corporate earnings fall by more than NIPA profits— closer to 30% plus. Such a drop in profits and earnings has devastating effect on stock prices.

Second, recent data on Q3 earnings already suggest a fall in earnings in Q3 of 8.3% relative to a year ago and a fall in earnings relative to Q2. Third, on a (business) cycle adjusted basis, P/E ratios are still very high: especially as both profits and earnings now look peaky and bound to sharply slow and/or fall in growth, P/Es are likely much too high considering the likelihood of a hard landing and the consequent sharp fall in earnings. Of course, the fact that valuations have been relative moderate for a number of years may imply that not all stocks will be hit as hard in a recession: many will gradually fall during the economic downturn but others, that have low valuations now and whose earnings would be less affected by a recession, may do relatively better or not as bad as the overall market. It may also be the case that, the stock market will fall by less than the average in a typical recession. Still, it is hard to avoid the conclusion that a recession would be really bad for the stock market. In every previous recession equities have done very poorly and it is hard to make a logical or empirical argument why in the next recession things would be meaningfully different.

Finally, notice that the equity valuations of homebuilders, financials, and discretionary consumption firms have already followed the pattern that I described above: a sharp fall in earnings followed by a sharp fall (about 20% or more in equity valuations).

The discussion above clarifies what one should expect if— as I have predicted— the current US slowdown accelerates into a recession: based on historical experience the stock market is likely fall sharply by about 28% from its peak to its trough before it starts to recover in the late stage of the recession.

[ Normxxx Here:  That would be about 4000 points down from its peak around 14200— or about a low of 10,200.  ]

So beware of the large amount of spin that is being peddled by bulls that are only now starting to recognize that a recession is likely: they need to spin the bad news about the economy as suggesting that such bad news is actually very good news for the stock markets or that the Fed will be able to prevent such a recession. For these perma-bulls good economic news is very good for the stock market and bad economic news is also very good for the stock markets— as exemplified by the reaction ("I guess it is probably a buying opportunity") to my recession call by a recent Squawk Box anchor interview suggests. But savvy investors will not allow themselves to be fooled by such non-sequitur arguments and will cautiously adjust their portfolio to reduce the risk of being stuck in a bear market once the recession actually gets under way.

[ Normxxx Here:  Unfortunately, this recession is likely to prove more delayed (and delayable by the powers that be) than most— and the pre-recession period could easily drag out until summer of 2008 or even as late as autumn of 2009]

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Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

The Next Credit Scandal

The Next Credit Scandal

By Peter Eavis, senior writer | 27 November 2007

NEW YORK (Fortune)— The major banks have already reported billions in unexpected losses from complex investment vehicles known as CDOs. Now they face big risks from other corners of the debt markets— but don't expect them to warn investors anytime soon.

The failure by banks to properly inform shareholders of their potential losses is perhaps the biggest scandal so far of the credit crunch that began this summer. Earlier this year, for example, Merrill Lynch, Citigroup and Bank of America gave almost no indication that one particularly toxic debt product— CDOs, or collateralized debt obligations— could be the source of billions of dollars in losses.

Those losses came to light this fall, blindsiding shareholders and pummeling banks' stock prices. The lack of disclosure not only has unsettled investors, but also has raised the prospect that large losses are lurking in other parts of the banks' businesses.

One likely new trouble spot: Conduits, the opaque structures banks set up to provide debt funding to borrowers. Often, the debt issued by the conduits is collateralized with assets, like mortgages.

Conduits typically aren't consolidated on a bank's balance sheet. But banks are often on the hook to fund them if investors stop buying the debt they've issued. When that happens, a lot of risk can get moved onto the balance sheet [[and very quickly! : normxxx]].

In a similar way, a good chunk of Citigroup's CDO losses occurred because it had to honor prior commitments to fund a large amount of debt previously issued by CDO structures. The financial services giant was ultimately forced to bring onto its balance sheet $25 billion of short-term CDO-debt backed with risky mortgages. (CDOs explained)

Now, conduits could trigger a similar process at many big banks. Since demand for certain types of conduit debt has shrunk dramatically and bad loan numbers on subprime debt are soaring, banks could well end up absorbing large amounts of conduit debt. Citigroup had off-balance sheet conduits with assets totaling $73 billion as of Sept. 30. And Merrill bought $5 billion of assets from its conduits in the third quarter, a move that led to pre-tax losses of over $500 million in the same quarter.

Almost every major banks has significant conduit exposure. But if conduits are becoming a problem, banks are not saying much about it in their financial statements. A close look at what happened with CDOs at Citigroup and Merrill shows just how little investors are told— and should make investors very wary about how little they know about banks' exposure to conduits.

So Why Was Cdo Exposure So Secret?

Banks typically arranged and sold CDOs to investors, so the sold ones would not appear on their balance sheets. In fact, there was one place in financial statements where numbers were given on CDOs. The disclosure was inadequate, but still worth looking at now.

In quarterly financial statements, companies disclose their "variable interest entities," or VIEs. These are entities to which a company has actual or potential economic exposure. When it comes to inadequate CDO disclosures, the VIEs that matter are those that are not consolidated on a company's balance sheet.

A word search for CDO in a public financial statement may have taken an investor to the VIE tables. But once there, there would be no way of gauging just what the true exposure was to CDO losses. This is partly the fault of the accounting rule— something called FIN46-R— that governs off-balance sheet VIEs. The big problem is that it doesn't force companies to disclose realistic estimates for losses.

Under FIN46-R, companies must disclose their maximum loss exposure. That sounds like a conservative approach, but in practice it isn't. That's because banks often add comments in financial statements that effectively tell investors not to take these maximum loss numbers seriously. Take a look at Citigroup's second quarter filing, posted Aug. 3, which was well into the summer credit meltdown. In it, the bank said actual losses from its unconsolidated VIEs, which included $75 billion of CDOs, were "not expected to be material." It has since estimated losses could be between $8 billion and $11 billion (which is most definitely material).

So the question becomes: Did banks have a good idea of what off-balance-sheet CDO losses would be before they were disclosed? The answer to that is: Almost certainly. Even if FIN46-R doesn't demand that banks disclose their estimates for actual losses, if such losses are material, other accounting guidelines demand they be made public. And recent financial statements clearly indicate that banks have closely and continuously estimated the value of their financial commitments— even those to off-balance sheet entities, like CDO structures.

If a change in the estimated value of a financial commitment to an off-balance-sheet entity produces a loss, that also generates a loss on the income statement. Both Merrill and Bank of America say in recent financial statements that their income statements have already been recognizing value changes in commitments to provide funding to CDOs. For Citigroup, it was these sorts of CDO funding commitments that led the bank to take $25 billion of CDO debt onto its balance sheet.

If Citigroup were valuing that commitment in the same way as Merrill and Bank of America, then it would presumably have taken at least some losses on it before the CDO debt came on its balance sheet. And those loss estimates should have been rigorous and sophisticated. That's because FIN46-R guides companies to give probabilities to different loss scenarios for its unconsolidated entities. In other words, if FIN46-R were being followed, all the banks concerned should have been able to produce internal estimates for a range of loss scenarios— and they would have been doing so as the credit crunch started this summer.

"We are confident that our financial statements fully comply with all applicable rules and regulations," said Citigroup spokeswoman Christina Pretto. Just think how much better warned investors would have been if those actual loss estimates had been made public. And just think how useful it would be to know those loss estimates for distressed conduits the banks must deal with now.

Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Credit Crisis to Credit Crunch

Credit Crisis to Credit Crunch

By John Mauldin | 9 November 2007

Just when it felt like it was safe to get back in the water, a second and potentially much meaner version of this summer's credit crisis has reappeared. This week we look at why there are more mortgage write downs coming (in a self-fulfilling prophecy) in the financial sector, how an obscure new accounting rule is shedding light on a lot of risk in the world's banking system, how this is all tied to the consumer and is part of the reason for the fall in the dollar. It's a complex world, and I am going to spend a considerable part of a beautiful Friday evening in Texas trying to make it simple for you, gentle reader. That's my job, and I love it. And since I can't think of my usual "but first" we'll jump right in.

A Confidence Credit Crunch Credit Crisis

I have written for some time that we are in a credit crisis brought on by a lack confidence which has the real possibility of devolving into a credit crunch which will make loans harder to get and has the potential to slow down the US economy, on top of a weakening consumer. Data released in the past few months, and again this week, have shown that banks and other lenders are tightening their standards for all sorts of loans. And it is not just that they are becoming more like an old-fashioned banker who actually wanted to know that he could get his money back. Their new found conservatism is being forced on them. But let's start at the beginning.

The Financial Accounting Standards Board (FASB) is the referee for accounting practices. They recently issued a new rule which [was] implemented November 15. Essentially, Statement 157 requires a financial firm to divide its assets into three categories called simply enough, Level 1, Level 2 and Level 3. Under FASB terminology, Level 1 means assets that can be marked-to-market, where an asset's worth is based on a real price, like a stock quote. Level 2 is mark-to-model, an estimate based on observable inputs which is used when no quoted prices are [readily] available. You can go get several bids and average them, or base your assumption on what similar assets sold for. Level 3 values are based on "unobservable" inputs reflecting companies' "own assumptions" about the way assets would be priced. That would be market talk for best guess, or in some cases SWAG (as in Scientific Wild-A**ed Guess, or, a WAG with numbers.) Financial companies have never had to break out this information. As you might expect, there is particular interest in how much and what kind of Level 3 assets a bank or brokerage firm might have. It turns out, that there may be more problems lurking in those assets than we realize.

Nouriel Roubini gave us some numbers earlier this week. It seems that some companies have far more Level 3 assets than they have capital. Take a look at these six banks which have already posted their Level 3 assets ahead of the deadline:

Citigroup Equity base: $128 billion
Level 3 assets: $134.8 billion
Level 3 to equity ratio: 105%

Morgan Stanley Equity base: $35 billion
Level 3 assets: $88 billion
Level 3 to equity ratio: 251%

Lehman Brothers Equity base: $22 billion
Level 3 assets: $35 billion
Level 3 to equity ratio: 159%

Goldman Sachs Equity base: $39 billion
Level 3 assets: $72 billion
Level 3 to equity ratio: 185%

Bear Stearns Equity base: $13 billion
Level 3 assets: $20 billion
Level 3 to equity ratio: 154%

Merrill Lynch Equity base: $42 billion
Level 3 assets: $35 billion
Level 3 to equity ratio: 38%

Now just because something is illiquid does not mean that it has no value. Real estate may be considered illiquid and have no "observable" price, but there is [obviously some] value. The same can be said for private equity holdings. There are often very good business reasons to hold such assets.

But as the Financial Times noted this week, valuing these assets is not easy.

"As the technology bubble imploded, fund managers stopped pretending to know what ethernet routers did and started asking what life would look like if all tech stocks halved in value. The structured credit market has yet to reach this moment of clarity. As is typical when the sky falls in, many specialists, obsessed with complexity, point to the impossibility of generalizing about the weather. "It is true that in terms of the vintage and profile of the underlying collateral, and the priority of claims on it (subordination), a dazzling range of permutations exist for collateralized debt obligations. And the subprime "write-offs" so far from the three banks worst hit suggest intellectual chaos [[and is perfectly laughable: normxxx]]: relative to their remaining exposure to "super-senior" CDOs, UBS wrote down 8 per cent, Merrill Lynch 41 per cent, while Citigroup's guidance is 19 per cent."

[ Normxxx Here:  And, we won't even consider Goldman Sachs, who would have us believe that they escaped unscathed.  ]

So we really do not know much more than what we have above. There is no break out (that I could find) that details what is in Level 3. Where are the mortgage CDOs and 'conduits'? Are they Level 2 or Level 3? There is going to be a demand for yet more transparency as this information yields a lot of questions. Among other things, how much do Level 3 assets contribute to your net capital position? And that is important because your net capitalization (net cap from here on) determines how much you can lend.

How Much is That Dog in Your Net Capitalization?

First off, there were some analysts who are writing that the sky is falling and that banks are going to have to write-down massive amounts of capital destroying their capital structure. Not true. Let me give you a simple analysis. Stay with me as this will be important later.

I own what may be the world's least complex broker-dealer (member FINRA) and a futures firm (member NFA). As 99% of my business is basically referral, I simply get a few checks each month, and pay expenses. But even though I directly handle no client assets, I still have to have a certain minimum capitalization in the business, as is required by FINRA and the NFA. So, I simply keep my required capitalization in a CD (certificate of deposit) in a bank. But it is not that simple. I have to make sure (or Tiffani does) that at the end of the month we deduct all the liabilities against that CD (notice I did not say cash). If for some reason revenues are less than projected and expenses (like legal bills) were more that anticipated, I would have to find capital to put into the company in order to keep my net capitalization ("net cap") above my required amount. Now, in figuring the net cap, all assets are not equal. That CD, for example, is only worth 99.5 cents on the dollar toward my capital, because FINRA assumes that there could be a penalty for early withdrawal. That 1/2% deduction is called a haircut. Different types of assets get different haircuts. Some haircuts on volatile or illiquid assets can be very steep. And I can guarantee you the regulators pay very close attention to your net capital reports. So, the Level 3 assets which are just now being reported have already been given an appropriate haircut. The fact that financial firms are disclosing the difference in the quality of assets has very little (or should have very little) to do with how those assets contributed to their net cap prior to the disclosures.

However, that does not mean that certain assets and specifically anything related to mortgages are not going to come under continued pressure [[e.g., if RE mortgage default rates were to rise materially from here— if we have a recession any time in the next several years! : normxxx]]. Estimates of $200-$250 billion in losses from subprime exposure are common [[based on current conditions: normxxx]]. Royal Bank of Scotland Group chief credit strategist Bob Janjuah put out a report Wednesday estimating that the credit crunch will cause $250 billion to $500 billion of losses at banks and brokers around the world.

"This credit crisis, when all is out, will see $250 billion to $500 billion of losses," said Janjuah, who's based in London. "The heat is on and it is inevitable that more players will have to revalue at least a decent portion of assets they currently value using 'mark-to-make-believe.'"

(I should note that the majority of these assets are not in banks but in pension funds, insurance portfolios, hedge funds, etc. Those losses have not yet been accounted for.)

Below is a table from http://www.markit.com. It is a list of various mortgage asset backed indexes based on securities that were created in 2006 and 2007. The indexes are composed of 20 different asset backed securities from major investment houses. These securities are in turn comprised of loans that were made in 2005-2007. For instance, the top index is the ABX-HE-AAA 07-2, which means this is an Asset Backed Security, Home Equity and all the securities in the index are AAA rated tranches and the securities were put together in the second half of 2007. The securities have a potential life of 30 years, by which [time] all the loans would have been paid.

The first five indexes listed are the various tranches of the same 20 securities. The next five listed are for another series of indexes created from 20 different asset backed securities put together in the first part of 2007. The next five are from 2006. The bottom five are from a group put together in early 2006 comprised of loans from 2005.

Once again. Each of these represents an index comprised of 20 different asset backed securities with the same rating from various ratings agencies. These indexes are created so that investors can hedge their portfolios if they want to, and traders can speculate either long or short. You can view more details and the actual securities if you are morbidly curious at the website.

Now notice something interesting. The AAA tranche from the top index, the one created just a few months ago, has lost over 30% of its value. Yet the AAA tranche from the first index series (in 2006) is only down 5.87%. The same relationship holds with whatever rating you want. The older it is, the less the losses. Further, an A-tranche from 2007 is not worth what a BBB-tranche is from just two years ago!

Clearly the market is saying that loans that were made in 2007 are not worth nearly as much as loans that were made in 2005. And guess which mortgages are more likely to be on investment bank books?


Click Here, or on the image, to see a larger, undistorted image.

Now, for those of us who are visual, let's look at what that AAA tranche has done since its inception just five months ago. This index was trading at $.96 just a little over one month ago, and is now down to $.69!!! The drop in value has been in one month.


Click Here, or on the image, to see a larger, undistorted image.

Many analysts are wondering why Merrill and Citigroup first stated losses to be one amount and then came back a few weeks later with another much larger amount. Looking at the above graph makes it at least partially clear. While the above chart is the steepest in terms of a drop in the last month, all the other indexes showed similar volatility in October.

Quite simply, assets that had one value at the beginning of the month had another value at the end. Further, many of those assets have fallen further in the last week. This suggests that further write downs are around the corner. There is still pain in the days and weeks to come for many of the best known financial names.

Remember that net cap issue we discussed earlier? Now we come to the relevance of what would normally be an arcane and uninteresting subject. When you submit your net cap reports, you have to justify the value you place on the assets.

It used to be (and not so long ago) you could play some games, like taking the bid price on an asset one quarter and the ask price the next, depending on whether you wanted to increase your earnings or "bank" some earnings for the future. It allowed for some gaming of the numbers. Now you have to show a consistent methodology. Further, the accounting firms are far more rigorous in a Sarbanes-Oxley world. They are far more insistent that clients show realistic numbers.

You cannot go to a regulator and say, "We think the market is crazy and we are not going to mark this asset down." As my Dad used to say, "That dog won't hunt."

The ABX indexes create a price comparison that cannot be ignored when you are putting together your accounting for your net cap reports. If the index is dropping, you are going to have to mark your assets down if you have similar assets on your books. Period, end of story. You can lose a great deal if you don't. It is not worth it.

Let's take a side trip for a moment and look at a 2002 vintage AAA mortgage backed asset. It is probably still capable of being rated AAA. Why? Because the bad lending practices were not prevalent, any mortgages still in existence have been paid on for almost six years, and the underlying homes may have appreciated anywhere from 50-100%. It would take a disaster of biblical proportions for that AAA tranche to lose money. By that I mean that 60% of the loans would have to lose 50% of their 2002 value (or 75% of their 2007 value) for the investor to lose money. Not very likely.

So, to the extent that banks and investors have "seasoned" senior mortgage backed securities, they are just fine. Where they are losing money is on the recent vintage mortgages that they could not get off their books and into the hands of their clients in time as the asset backed market simply has ceased to function.

Looking at the graph suggests that because of the significant drop since the end of October there are further potentially large markdowns coming unless these indexes reverse themselves and go back up. Put another way, if the banks had to mark to market today, the losses they announced last week would be even higher. And potentially a lot higher.

Banks which have write downs and losses have to raise capital to meet net cap requirements. One of the ways you can do that is by making fewer loans. Thus, banks are tightening up their lending standards.

But there is another reason that lending standards are higher. Many banks no longer function as what we think of as banks in the "old days" of 20 years ago. Today a bank uses its capital to make a number of loans and then packages them up and sells them as a security to another investor. Banks are now originators of loans rather than long term lenders.

But the institutions which are the ultimate market are demanding higher quality loans, and thus originators are responding to the market demand. So far, there is little new CDO issuance, and no subprime securities to speak of. But standards are going to get tighter for all sorts of paper. Capital One informed us today that credit card delinquencies are up over a full percentage point from this time last year to 4.75%. Do you think that investors will buy credit card paper at the same terms as last year? The market for credit card asset backed securities is almost $700 billion. Rates are going to go up, and credit will be harder to get for those with less than pristine credit.

There is a distinct lack of confidence in the ratings of asset backed securities of all types. We do not have a liquidity crisis. We have a confidence crisis. As we see capital implode and confidence erode, we are facing the real possibility of a full blown credit crunch.

(By the way, this is not just a US problem. You can bet similar problems are going to crop up in institutions all over Europe.)

King Dollar Faces the Guillotine

But there is yet another problem facing the credit markets and that is the erosion of the value of the US dollar. Some argue that a falling dollar is good for the US because it makes our exports cheaper, and indeed exports are rising. But there is more to the falling dollar than improving our exports.

Look at this chart provided me by South African partner Prieur du Plessis's Investment Postcards blog. It is what a European investor would have lost if they had invested in a ten year US treasury note, down an ugly 7% in a government bond after today's bond sell-off.


Click Here, or on the image, to see a larger, undistorted image.

If you own the Dow, you are down [even] after today in terms of the euro. And that is pretty much the case for most currencies. It is why [several] prominent Chinese official suggested that China should start to put more of its assets in stronger currencies, touching off a very quick drop in the dollar. The euro and the pound are [around] 5% higher than they were at the beginning of September when I was in Europe.

If you are a foreign investor, why would you want to invest in dollar denominated assets in which you are not totally confident? Sure, you can hedge your currency risk, but hedging is not without cost, and that cost will be born by the borrower which is to say American businesses and consumers.

Think about this for a moment. If you are China, you could reduce your energy bill by 20% just by letting your currency rise. Not to mention the cost of copper, steel, nickel and other commodities. And did I mention all the massive food imports China requires? Yes, keeping your currency low has helped you to get a competitive advantage in manufacturing all sorts of products. But at some point it will make more sense to have a stronger currency.

The Euro-Yen Cross

Two quick notes before we close: Greg Weldon noted in Weldon's Money Monitor that came out tonight the very tight correlation between the US stock markets and what is known as the Euro-Yen cross, or the Euro as denominated in yen.


Click Here, or on the image, to see a larger, undistorted image.

This cross is a proxy for the yen carry trade. It is a clear example of the appetite in the world for risk. That appetite went away in August but came back in September and October. It is once again heading down, which does not bode well for the stock market if it continues.

The Consumer is Getting Tired

Consumer sentiment is at a 15 year low, taking out the temporary spike down after Katrina. And it is showing up in consumer spending. Let's close with this note from friend Bill King (remove sharp objects from your vicinity).

"October US retail sales are at or near recession levels. Food inflation boosted warehouse sales. Wal-Mart sales increased 0.4% on heavy discounting; +1.1% was expected. WMT's sales are flat ex— Sam's Club (+4.2%, which is mostly from increased food sales) and are down 0.3% ex-gasoline. Nordstrom reports a decline of 2.4%; +1.3% was expected. Macy's sales declined 1.5%;— 0.6% was expected. Gap same-store sales declined 8%;— 4.7% was expected. Limited Brands (Victoria's Secret) reports same-store sales declined 6%;— 1.5% was expected. Chico's sales declined 10.6%;— 5.9% was expected. Abercrombie & Fitch same-store sales declined 2%;— 0.6% was expected. Ann Taylor sales declined 4.2%; +1.2% was expected. Target same-store sales increased 4.1% (+2.4% exp). Costco same-store US sales jumped 7% (food). "The National Retail Federation and TNS Retail both forecast the smallest holiday sales growth in five years. The NRF includes purchases in November and December in its forecast. TNS uses sales during October, November and December. The Int'l Council of Shopping Centers said October sales increased 1.6%, the worst October in 12 years. "Bloomberg's Same-store Sales Index increased 1% in Oct; year-to-date sales are +1.5%. The only reason for being positive is the warehouse clubs index increased 5.3%. It's the food inflation, stupid!"

Jim Cramer used the "R" word on his show [the other] night: recession. I think it is more likely than not. The Fed is going to cut and cut again. The dollar is going down some more. It is dangerous out there for relative return investing.

Normxxx    
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Market Bounce Coming

Market Bounce Coming

By Brian Bloom | 27 November 2007

The Dow Jones Industrial Index is now badly oversold from a technical perspective, and it looks more likely that the markets will bounce up than "collapse". Having said this, the most important chart in the array of charts seems to be the Dow Jones Industrial Index below.


Click Here, or on the image, to see a larger, undistorted image.
(Charts Courtesy Bigcharts.com)

If we focus on the On Balance Volume chart we see that, since October, there have been a series of falling bottoms— and about a week ago, the OBV fell to a new low. This constituted a "sell" signal. Since then it looks like it wants to rise because the there has been a series of three rising lows in the last week.

To give you some context, the chart below is the same chart, but it shows a 12 month period.


Click Here, or on the image, to see a larger, undistorted image.

Since around May this year, the OBV has been hovering around the 5-7.5 billion share mark, and the OBV is now closer to the 5 billion mark.

If you now look at the next chart— which is the same chart dating back to 1998, you see that the OBV started rising strongly in mid 2003— following what is known as a "non confirmation" by the MACD. In late 2001, the MACD fell to a low when price fell to a low, but in 2002, when the price fell to a lower low, the MACD low showed rising lows


Click Here, or on the image, to see a larger, undistorted image.

Now let's focus on the MACDs in the three charts. Note how the MACD fell to a lower low in November than in August (in the first chart) Note the series of three descending lows in the MACD in the second chart Note, in the last chart, that the MACD at -500 is far higher than the 2001 low of -1,000. There is a formation on the 10 year chart above— known as a "megaphone" formation— which has been slowly emerging in 2007.

Since about June, there have been three successive rising tops and also three successive falling bottoms in the price chart. This is a sign of confusion. The bulls have been increasingly bullish and the bears have been increasingly bearish.

That's why the On Balance Volume Chart is so important. It tells you who is winning the war.

The first chart above shows that, during the period when the megaphone was being formed, on balance, sellers prevailed. There was less volume changing hands when the three new highs manifested that there was when the three new lows manifested. Net, Net, selling pressure has prevailed. Having said this, selling pressure has been subtle. It does not reflect urgency so much as opportunism.

My interpretation of all of the above is that, with the market very badly oversold, it should bounce upwards in the very short term— but this will be a sucker rally. I don't think the market will rise to new highs [[probably just another chance for the "smart money" to leave— before next summer. But, it would seem, that the "positive" season has begun (or is about to).: normxxx]].

So far, the above does not show signs of any coming "Panic". More likely we will see a series of hopeful rallies followed by a series of agonising falls— with a bias to the downside. The 11,000 level seems like it will offer significant technical support, and the 13,000 level now represents resistance.

The days of easy money "day trading" profits are behind us.

Now let's focus on gold. Does this represent a "safe haven"?

The biggest single issue relating to gold is that it has highly emotive connotations. This is not an accident of history. There are significant practical reasons for this, which have nothing to do with "money". These reasons are too involved to be explained here, and so we need to cut through all the "theory" and look at the charts.

The first chart below shows gold relative to the $CCI commodity index on a weekly basis: (Courtesy stockcharts.com)


Click Here, or on the image, to see a larger, undistorted image.

This is not an easy chart to interpret. From a bullish perspective, one could argue that— since April— there has been the emergence of a "saucer" formation. If it breaks through the 1.9 level it might scream upwards relative to commodities.

From a bearish perspective, the MACD looks overbought as does the RSI.

Now, if we look at the daily charts, this is even more confusing:


Click Here, or on the image, to see a larger, undistorted image.

Here the MACD looks like it is turning up, as is the RSI. Also, the price chart peaked and has been "neatly" consolidating as it pulled back to the 40 day Moving Average line— from which it is now bouncing up.

The saucer and the double top are clearly seen from the P&F chart below, and the three green Xs seem to show a healthy sign that the ratio will at very least consolidate around this level.


Click Here, or on the image, to see a larger, undistorted image.

If we take a step back and look at the P&F chart, sensitised for a 3% X 3 box reversal, we see that a break to new highs will likely be very bullish. We could see the ratio rising to around 202


Click Here, or on the image, to see a larger, undistorted image.

The question is whether this will arise from an "explosion" in the gold price, or a fall in the prices of commodities in general.

The chart below is a 2% X 3 box reversal chart of the $CCI commodities index


Click Here, or on the image, to see a larger, undistorted image.

This is hardly a bearish chart at present, but it might pull back to (say) the 430 level.

It would be easy to argue that "therefore, the market is expecting inflation, and all commodities should rise, with gold rising faster than everything else."

This argument is, in my view, too easy. The reason is that if the market was expecting inflation, long term interest rates should be rising.

[ Normxxx Here:  but what if it's stagflation that's expected?  ]

The following chart shows that, contrary to expectations, long dated yields are falling.


Click Here, or on the image, to see a larger, undistorted image.

So, with all the above in mind, where does the argument lead?

Overall Conclusion

It looks like "negativity" is the dominant emotion in the market, but right now this fear is manifesting more as caution than fear. Investors are moving to protect themselves.

Some are moving to put their money into hard assets, whilst others are moving to put theirs into government bonds. If hard assets become the "flavour of the month" then gold will likely outperform all the others.

Will there be a market crash? It is possible but, based on the current technical situation (which might change) I doubt it. Technically, the information above is biased slightly to the negative. It is not (yet) showing signs of panic. Fundamentally, if the market were to collapse at this point, it would be a collapse from which there would be no recovery.


Normxxx    
______________

The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.

The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.

Nightmare Economic Scenario

New Wave of Mortgage Failures Could Create a Nightmare Economic Scenario

By Joe Bel Bruno, AP Business Writer | 26 November 2007

NEW YORK (AP)—

When Domenico Colombo saw that his monthly mortgage payment was about to balloon by 30 percent, he had a clear picture of how bad it could get. His payment was scheduled to surge by an extra $1,500 in December. With his daughter headed to college next fall and tuition to be paid, he feared ending up like so many neighbors in Ft. Lauderdale, Fla., who defaulted on their mortgages and whose homes are now in foreclosure and sporting "For Sale" signs. Colombo did manage to renegotiate a new fixed interest rate loan with his bank, and now believes he'll be OK— but the future is less certain for the rest of us.

In the months ahead, millions of other adjustable-rate mortgages like Colombo's will reset, giving them a higher interest rate as required by the loan agreements and leaving many homeowners unable to make their payments. Soaring mortgage default rates this year already have shaken major financial institutions and the fallout from more of them, some experts say, could spread from those already battered banks into the general economy.

The worst-case scenario is anyone's guess, but some believe it could become very bad. "We haven't faced a downturn like this since the Depression," said Bill Gross, chief investment officer of PIMCO, the world's biggest bond fund. He's not suggesting anything like those terrible times— but, as an expert on the global credit crisis, he speaks with authority. "Its effect on consumption, its effect on future lending attitudes, could bring us close to the zero line in terms of economic growth," he said. "It does keep me up at night."

Some 2 million homeowners hold $600 billion of subprime adjustable-rate mortgage loans, known as ARMs, that are due to reset at higher amounts during the next eight months. Subprime loans are those made to people with poor credit. Not all these mortgages are in trouble, but homeowners who default or fall behind on payments could cause an economic shock of a type never seen before.

Some of the nation's leading economic minds lay out a scenario that is frightening. Not only would the next wave of the mortgage crisis force people out of their homes, it might also spiral throughout the economy. The already severe housing slump would be exacerbated by even more empty homes on the market, causing prices to plunge by up to 40 percent in once-hot real estate spots such as California, Nevada and Florida. Builders like Chicago's Neumann Homes, which filed for bankruptcy protection this month, could go under. The top 10 global banks, which repackage loans into exotic securities such as collateralized debt obligations, or CDOs, would suffer far greater write-offs than the $75 billion already taken this year. Massive job losses would curtail consumer spending that makes up two-thirds of the economy. The Labor Department estimates almost 100,000 financial services jobs related to credit and lending in the U.S. have already been lost, from local bank loan officers to traders dealing in mortgage-backed securities. Thousands of Americans who work in the housing industry could find themselves on the dole. And there's no telling how that would affect car dealers, retailers and others dependent on consumer paychecks. Based on historical models, zero growth in the U.S. gross domestic product would take the current unemployment rate to 6.4 percent. That would wipe out about 3 million jobs from the economy, according to the Washington-based Economic Policy Institute. By comparison, in the last big downturn between 2001-03 some 2 million jobs were lost, according to the Labor Department. The dot-com bust early this decade decimated the technology sector, while the Sept. 11, 2001, terror attacks hurt the transportation and allied industries. Economists said the country was officially in recession from March to November of 2001, but the aftermath stretched to 2003.

There is increasing evidence that another downturn has begun.

Borrowers who took out loans in the first six months of this year are already falling behind on their payments faster than those who took out loans in 2006, according to a report from Arlington, Va.-based investment bank Friedman, Billings Ramsey. That's making it even harder for would-be buyers to get new mortgages— a frightening prospect for home builders with projects going begging on the market, and for homeowners desperate to unload property to avoid defaulting on their loans.

Meanwhile, the number of U.S. homes in foreclosure is expected to keep soaring after more than doubling during the third quarter from a year earlier, to 446,726 homes nationwide, according to Irvine, Calif.-based RealtyTrac Inc. That's one foreclosure filing for every 196 households in the nation, a 34 percent jump from just three months earlier.

Such data suggests more Americans could lose their homes than ever before, and those in peril are people who never thought they'd welsh on a mortgage payment. They come from a broad swath— teachers, pharmacists, and civil servants who were lured by enticing mortgage terms.

Some homebuyers gambled on interest-only loans. The mortgages, which allowed buyers to pay just interest at a low rate for two years, were too good to pass up. But with that initial term now expiring, many homeowners find they can't make the payments. The hopes that went along with those mortgages— that they'd be able to refinance because the equity in their homes would appreciate— have been dashed as home prices skidded across the country.

"It's been said a lot of people have been using their homes as ATM machines," said Thomas Lawler, a former official at mortgage lender Fannie Mae who is now a private housing and finance consultant. "The risk has a lot of tentacles."

This example illustrates the distress many homeowners are in or will find themselves in: A subprime adjustable-rate mortgage on a $400,000 home could have payments of about $2,200 a month, with borrowers paying 6.5 percent, interest only. When the teaser period expires, that payment becomes $4,000, with the homeowner paying 12 percent and now having to come up with principal as well as interest.

Minneapolis resident Chad Raskovich found himself in a such a situation. He hoped— it turned out, in vain— to gain more equity in his home and that a strong record of payments would enable him to secure a better loan later on.

"It's not just me, it's a lot of people I know. The housing market in the Twin Cities has dramatically changed for the worse in the years since I purchased my home. Now we're just looking for a solution," he said.

Colombo, who lives in the planned community of Weston just outside Ft. Lauderdale, said the reset on his home would have "destroyed" his financial situation. He went to Mortgage Repair Center, one of hundreds of debt counselors trying to bail out desperate homeowners, to work with his lender.

"But many people in my neighborhood didn't get help, and some have literally just walked away from their homes," said Colombo. "There are over 133,000 homes on the market in Broward-Miami-Dade counties, and some of them were actually abandoned. People in this situation don't like to talk about it, and end up getting badly hurt because they don't."

Many Americans are unaware that a borrower defaulting on a loan can have an impact on everyone else's well-being and that of the nation. After all, the amount of mortgages due to reset is just a fraction of the United States' $14 trillion economy.

But the series of plunges that Wall Street has suffered in past months prove that no one is immune when mortgages turn sour. Today's financial system is interconnected: Mortgages are sold to investment firms, which then slice them up and package them as securities based on risk. Then hedge and pension funds buy up such investments.

When home prices kept rising, these were lucrative assets to own. But the ongoing collapse in housing prices has set off a chain reaction: Lenders are tightening their standards, borrowers are having a harder time refinancing loans and the securities that underpin them are in jeopardy.

This has resulted in more than $500 billion of potentially worthless paper on the balance sheets of the biggest global banks— losses that could spill into the huge pension and mutual funds that also invest in these securities and that the average worker or investor expects to depend on.

There's more pain left for Wall Street: "We're nowhere close to the end of the collapse," said Mark Patterson, chairman and co-founder of MatlinPatterson Global Advisors, a hedge fund that specializes in distressed funds.

"I just assumed banks could stomach these kind of losses," said Wendy Talbot, an advertising executive when asked about the subprime crisis outside of a Charles Schwab branch in New York. "I guess you don't really pay attention to things until you're forced to. ... You put out of your mind the worst things that can happen."

The subprime wreckage could dwarf the nation's last big banking crisis— the failure of more than 1,000 savings and loans in the 1980s. The biggest difference is that problems with S&Ls were largely contained, and the government was able to rescue them through a $125 billion bailout. But this situation is far more widespread, which some experts say makes it more difficult to rein in.

"What really makes this a doomsday scenario is where would you even start with a bailout?" housing consultant Lawler asked.

Sen. Charles Schumer, D-N.Y., a key member of Senate finance and banking committees, said borrowers are the ones who need relief. The playbook to bail out the economy would not be applied to the banks and mortgage originators, but money could be funneled through non-profit organizations to homeowners that need help, he said in an interview with The Associated Press.

"There is a worst-case scenario because housing is the linchpin of our economy, and more foreclosures make prices go down, that creates more foreclosures, and creates a vicious cycle," Schumer said. "You add that to the other weakness in the economy— on one end is the home sector and the other is the financial sector— and it could create a real problem."

He also believes Federal Reserve Chairman Ben Bernanke should do more to help the economy. Bernanke said in recent comments he has no direct plans to bail out the mortgage industry, but to instead offer relief through cheap interest rates and further liquidity injections into the banking system.

There's also been talk of letting government-backed lenders like Fannie Mae and Freddie Mac buy mortgages of as much as $1 million from lenders, pay the government a fee for guaranteeing them and then turn them into securities to be sold to investors. This would extend the government's support, and its exposure, to the mortgage market to help alleviate stress.

[ Normxxx Here:  This overlooks the fact that both Fannie and Freddie are reporting losses and have long since run out of the capital to do any such thing!  ]

Either way, the impact of a fresh round of subprime losses remains of paramount concern to economists— especially since there's little certainty about how it would ripple through the U.S. economy.

"We all know that more hits from these subprime loans are coming, but are having a devil of a time figuring out how it will happen or how to stop it," said Lawler, who was once chief economist for Fannie Mae.

"We've never been in this situation before."

Normxxx    
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