Monday, July 30, 2007

Signs of the Economic Apocalypse, 7-30-07

From Signs of the Times:

Gold closed at 672.30 dollars an ounce Friday, down 1.8% from $684.70 at the close of the previous Friday. The dollar closed at 0.7337 euros Friday, up 1.5% from 0.7232 at the previous week’s close. That put the euro at 1.3630 dollars compared to 1.3827 the Friday before. Gold in euros would be 493.25 euros an ounce, down 0.4% from 495.19 for the week. Oil closed at 77.12 dollars a barrel Friday, up 1.8% from $75.79 at the close of the week before. Oil in euros would be 56.58 euros a barrel, up 3.2% from 54.81 for the week. The gold/oil ratio closed at 8.72, down 3.6% from 9.03 at the end of the previous week. In U.S. stocks the Dow Jones Industrial Average closed at 13,265.47, down 4.4% from 13,851.08 for the week. The NASDAQ closed at 2,562.24, down 4.9% from 2,687.60 at the close of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 4.76, down 19 basis points from 4.95 at the end of the previous week, and down 34 basis points over the last two weeks.

The plunge in stock prices last week has even the mainstream press rattled. The fear is that the plunge was more than a normal correction after a period of run-up in stock prices, that it marked the end of a long credit bubble. The investment banks that underwrote the Cerebus buyout of Chrysler are found last week that they can’t sell the debt.
Bubble Leaking

By Roddy Boyd

July 27, 2007 -- The stock market's rout yesterday was driven in large part by the realization among investors big and small that the woes in the mortgage-bond sector are spreading to other parts of the debt market.

While it has been hedge funds that have felt the brunt of pain caused by the giant hiccup in the subprime mortgage market, the latest wave of malaise is affecting everything from leveraged buyouts to what until now would have been considered run-of-the-mill bond offerings.

Weighing heavily on the markets was the sale of loans to finance Cerberus' purchase of Chrysler, which fell apart - saddling the JP Morgan Chase bank syndicate with $16.5 billion in debt. Now the bank will have to swallow a mammoth $10 billion for the time being.

Late Wednesday, a $10.3 billion deal to finance Kolberg Kravis Roberts & Co.'s purchase of Alliance Boots, a leading British pharmacy chain, was withdrawn after eight banks couldn't sell the debt.

Just yesterday, Tyco Electronics, which was spun off from conglomerate Tyco International, canceled its planned $1.5 billion bond offering citing "unfavorable conditions in the debt markets."

Meanwhile, the general partner at a $4 billion New York hedge fund told The Post that federal funds futures indicate an expectation that the Federal Reserve will ease interest rates within the next two months, which, if true, would signal an abrupt policy shift for the Fed after 17 straight Fed funds rate increases.

Whether this happens or not, the benchmark 10-year Treasury note rallied to yield 4.77 percent as the safest haven for battered investors, its lowest level since May.

Further fueling the malaise was yesterday's housing sales report, which showed sales dropping 6.6 percent and bad earnings Wednesday from home-loan giant Countrywide - which showed that mortgage payment woes were spreading to middle- and upper-income borrowers.

Key Wall Street indexes are telling traders that the rout is not likely to stage a reverse soon.

A highly watched asset-backed bond index comprised of AA-rated bonds - the ABX 07-1 index - dropped six points yesterday. It usually moves a point or two, traders told The Post.

Other ABX indexes covering A-rated to BBB-rated bonds dropped between three and five points.

Bond investors and speculators are casting doubt on the future health of Wall Street's investment banks, which have been shattering quarterly and annual earnings records over the past five years.

Many now hold billions of dollars in mortgage bonds and other illiquid assets, which are expected to weigh on their results in upcoming quarters.

That’s how the end begins. As long as investors were willing to buy all that junk debt, the party could continue. If investment banks can’t sell the bonds anymore, that means that the very thing that has been keeping the markets above water is now gone. All these leveraged buyouts have kept stock prices rising recently, but when there is no leverage left, there will be much fewer buyouts. Cadbury-Schweppes had to postpone indefinitely the sale of their U.S. soft-drink arm, Dr. Pepper/7-Up, because banks won’t underwrite the debt. Underwriting means issuing bonds, so if banks issue the bonds and no one buys them, the banks are assuming all the risks in the deal. This is what happened with the Cerebus-Chrysler deal. All this was a completely predictable result of the bursting of housing bubble. The only thing hard to predict was the exact timing.

Mortgage lending crisis sparks Wall Street plunge

By Patrick Martin

27 July 2007

A two-day selloff on Wall Street has slashed nearly 540 points from the Dow-Jones Industrial Average and wiped out hundreds of billions in stock market value. The sharp decline, following so closely the breaking of the 14,000 mark by the Dow last week, underscores the increasing instability of the US and world financial system.

The mood during Thursday’s trading was widely described as one of “panic” and “fear,” as stock traders reacted to a torrent of bad economic news: sharp declines in the sales of new and existing homes, a further spike in oil prices, a poor showing for US durable goods orders, and financial difficulties for two high-profile corporate takeovers.

The Dow-Jones was down nearly 450 points by mid-afternoon, only to recover somewhat in the final hours of trading. Overall, declining stock issues led advancing ones by a 14 to 1 margin, and the trading was extremely heavy, with a record volume on the New York Stock Exchange of 2.78 billion shares.

Thursday’s slide in New York was felt around the world, with European markets plunging during their final hours of trading Thursday as a result of the downdraft on Wall Street. The London Stock Exchange suffered its biggest loss in four years, with the FTSE 100 index falling 3.15 percent, and there were similar declines in Germany and France.

The initial trigger of the selloff was a report Wednesday by the National Association of Realtors that sales of existing homes fell by 3.8 percent in June to the slowest pace in more than four years. The following day, the Commerce Department reported that sales of new homes fell 6.6 percent in June, three times the drop expected and the largest in percentage terms since January.

The median sale price of a new home fell to $237,900—still nearly five times the annual income of the median family, but down 2.2 percent from a year ago. New home sales rose slightly in the South, but plunged 27.1 percent in the Northeast, 22.5 percent in the West and 17.1 percent in the Midwest. Sales of existing homes fell in all four regions, by amounts ranging from 1.7 percent to 7.3 percent.

There were other numbers contributing to the negative mood in the markets. The Commerce Department reported a 1.4 percent increase in durable goods orders, but if a huge one-time order for new aircraft is discounted, there was actually a drop in orders. Oil prices reached as high as $77 a barrel Thursday before dropping, and the US dollar fell by 1 percent against the yen, a large drop for a single day’s trading. But it was the quantitative and qualitative evidence of a collapse in the housing market that did the most damage.

On Tuesday, the top US mortgage lender, California-based Countrywide, announced it was compelled to take a write-off for losses due to late payments or defaults by borrowers. The company said that divorce and the loss of a job were the two leading reasons for borrowers failing to make payments, and that more borrowers with good credit were falling behind on their home equity loans, not just those with lower incomes and poorer credit who have taken out so-called subprime mortgages. The proportion of good-credit customers at least 30 days delinquent was 1.8 percent a year ago, and has nearly tripled to 4.6 percent now.

In a conference call with analysts, Angelo Mozilo, Countrywide’s chairman and chief executive, said home prices were falling “almost like never before, with the exception of the Great Depression.”

Pulte Homes, of Bloomfield Hills, Michigan, the second largest US home builder, reported a second quarter loss of $507 million, as opposed to a profit of $243 million last year, including a special charge for plummeting land values.

D.R. Horton Inc., the largest builder, reported a similar swing, from a $293 million profit in the second quarter last year to a loss of $824 million this year, including substantial write-offs for the declining value of houses and land. During a conference call with investors and financial reporters, Horton CEO Donald Tomnitz said that the crisis in subprime mortgage lending was having a direct impact on his company. “In some of our instances across the country we are trying to qualify the same buyer two and three times based upon the changing conditions in the mortgage industry,” he said. “We’re not predicting when there’s going to be a recovery because we don’t see one on the horizon.”

In the largest and most expensive housing market, California, foreclosures rocketed a staggering 799 percent for the three months ended June 30, compared to the same period a year ago. Some 17,408 homes were foreclosed during the quarter. Default notices were up 158 percent statewide during the same period.

Stock investors and the financial press have paid increasing attention to the crisis in subprime lending, because the exploitation of poor and vulnerable borrowers has become one of the most lucrative enterprises for mortgage originators and the various financial middlemen, from mortgage bankers to hedge funds, who collect their slice of profit from this high interest debt.

More than $1.2 trillion in subprime mortgages were originated in 2005 and 2006, the bulk of them sold to big mortgage brokers and repackaged as complex financial instruments bought and sold by hedge funds, private equity firms and other Wall Street high rollers, in a process known as “securitization.” The two largest credit rating agencies, Moody’s and Standard & Poor, have only recently begun to review and downgrade these securities, known as collateralized debt obligations or CDOs, to reflect the increasing number of defaults in mortgage payments.

The total amount of securitized subprime mortgages now tops $1.8 trillion, according to recent estimates by the financial press. Leading Wall Street figures have sought to stanch the growing concern that CDOs are a financial house of cards that will come crashing down as mortgage borrowers default. Federal Reserve Chairman Ben Bernanke told Congress last week that losses for big lenders on subprime mortgages could be as high as $50 to $100 billion, but he claimed that the wider impact would be limited.

Some analysts, however, have pointed to far-reaching dangers in the subprime meltdown. William Gross of Pimco Bonds warned July 24, in his monthly commentary, of a “sudden liquidity crisis in the high-yield debt markets.” The chain-reaction effect would be to undermine the availability of easy credit to finance leveraged buyouts, stock buybacks and mergers and acquisitions, the main forces driving up the price of stocks. He concluded, “No longer will stocks be supported so effortlessly by the double-barreled impact of LBOs and company buybacks.”

The practical effect of this process was visible already on Wednesday, as DaimlerChrysler was compelled to postpone the financing for the sell-off of its Chrysler division to the private equity firm Cerberus, which encountered difficulties in obtaining bank loans. The same day, bankers for another private equity giant, Kohlberg Kravis Roberts, withdrew $10 billion in loans meant to finance the buyout of Alliance Boots, a British drugstore chain. All told, some 20 such debt offerings have been postponed or revised because of growing pressure in the credit markets, including a plan by General Motors to sell its Allison Transmission unit to the Carlyle Group, another huge private equity firm.

A front page article in the Washington Post Thursday noted the common thread among events like the collapse of share prices for the Internet travel company Expedia, the mortgage lending crisis, and plunging value of shares in Blackstone, the private equity firm that went public last month.

“At the root of those seemingly unrelated events is a single new reality, one that could portend trouble for the broader US economy: The era of cheap money appears to be ending,” the newspaper observed. For years, easy credit had fueled a seemingly effortless rise in financial markets, “but now, the investors who a few months ago were willing to lend money to Wall Street at low interest rates, on loose terms, are balking as they worry about having to pay the price for lax lending standards.

“The trouble started in one of the shakiest sectors of finance, home mortgages for people with bad credit, but it is spreading. As easy credit dries up, some huge corporate deals are being delayed and could unravel. The question now is how far will the pain spread, and how many people will get hurt as it does.”

The pain may be spread very far:

Subprime could create global crisis, economist says
World is one "Bear-like' event away from liquidity freeze, Zandi warns

By Rex Nutting, MarketWatch

July 26, 2007

WASHINGTON (MarketWatch) -- The problems in the U.S. subprime mortgage market could spiral out of control into a global financial crisis, economist Mark Zandi said Thursday.

With a "high level of angst" in the financial markets about who will take the losses from more than $1 trillion in risky mortgages, we could be just one hedge-fund collapse away from a global liquidity crisis, said Zandi, chief economist for Moody's

A global meltdown is not likely, but the risks are growing, Zandi emphasized in a conference call with reporters following the release of a new study on subprime debt that concludes that the housing crisis could be deeper and last longer than investors now believe.

And it could spread. "Mounting mortgage delinquencies and defaults now pose the most serious threat to the global financial system and economy," Zandi said in his report.

"If there is a fault line in the global financial system, it runs through the U.S. housing and mortgage markets," he said.

Zandi's comments came as U.S. financial markets reeled from a growing credit crunch, centered not in the subprime arena, but in the leveraged corporate debt market.

On Thursday, Tyco became the latest multinational company to pull a deal because the buyers have fled. U.S. stock markets plunged Thursday, while U.S. Treasurys benefited from a flight to quality.

Treasury Secretary Henry Paulson, an old Wall Street hand himself, tried to reassure markets with a mid-afternoon televised pep talk. Lenders and borrowers should exercise more "discipline," he said, and he repeated his view that any problems in the subprime market would be "largely contained."

But Zandi and others say the problems are only beginning.

In a note to clients on Wednesday, Goldman Sachs chief economist Jan Hatzius said the housing correction could be less than half over, if history is any guide.

"The dramatic deterioration in the mortgage market suggests at least the possibility that the credit crunch in the mortgage finance industry could become as bad as in the bad old days of the 1970s and 1980s," Hatzius wrote.

Zandi used another historical comparison: the Asian financial crisis of the late 1990s.

"Unlike the financial crisis of a decade ago, however, global capital would likely flow away from U.S. markets, not to them, as the genesis for the crisis lies within the U.S. financial system."

After Bear Stearns was forced to write off the value of two large hedge funds that had invested heavily in securities backed by subprime debt, it could take just one more "Bear-like event" for the financial system to freeze up,

"If there's another major hedge fund that does stumble, that could elicit a crisis of confidence and a global shock," Zandi said. The potential "is quite high," he said. He gave it a one-in-five chance.

Zandi said global financial conditions have been supported by strong growth and substantial liquidity, supercharged by "unprecedented risk tolerance." But that's changing. Global liquidity is drying up, with central banks tightening. And risk is being re-priced.

"The credit window is now closed," wrote strategist Barry Ritholtz in his blog.

As for the U.S. housing market, Zandi expects a lot more pain, but not a recession.

Not a recession??? A meltdown unlikely??? Those statements by Zandi have the flavor of obligatory nods to etiquette of not wanting to cause panic but they have little relation to what he says elsewhere in the article. Those who manage “bear funds” have less obligations to put a positive gloss on things:
'Reckoning' begins for prophet of doom

Derek Decloet

July 28, 2007

For investors, this has been one rude interruption to a glorious summer. In the space of five days, the Dow was trashed, the FTSE fell, the Nasdaq went into a nosedive, and the TSX had its worst week since September, 2001. From Mexico City to Dublin to Bucharest to Sydney, it was nasty.

In a tiny office in midtown Manhattan, Nandu Narayanan (pronounced nar-EYE-uh-nan) ate it up. He loved it and had one of the best weeks of his career as an investor. He's been waiting for this. Did you see that Blackstone Group, the new cover boys for excess and greed in the private-equity age, has plunged 21 per cent since it completed its initial public offering, oh, about two hours ago? That the vultures at Cerberus Capital can't sell bonds to finance their big Chrysler deal? That Wall Street bankers are waking up at 3 a.m. in a cold sweat, having just dreamed of subprime loans? "The reckoning has started," he says.

Mr. Narayanan, who runs a shop called Trident Investment Management, might be the most unusual investor you've never heard of. He could have been a scientist, a famous economist, or a CEO. (His older sister, Indra K. Nooyi, is the chairman and top executive at PepsiCo and arguably the most powerful woman in Corporate America.) He graduated summa cum laude from Yale, studied under Paul Krugman at the Massachusetts Institute of Technology and acquired an MBA and a PhD in finance and economics from that institution. "He is the single smartest guy I've ever met in my life," says CI Financial's Bill Holland, which you could dismiss as fund-company marketing spin, except he's put $10-million of his own dough in Mr. Narayanan's hedge fund.

Instead of rocket science, he chose a different vocation: prophet of financial doom. Mr. Narayanan makes Eric Sprott look like a cheerful optimist. The credit squeeze that has put a deep-freeze on leveraged buyouts in July and forced this little stock market correction - this is just the beginning, he says. "I would say we're probably in the second or third inning." The best-case scenario? A replay of the summer of '98, when the Dow lost about 20 per cent in a month-and-a-half. The worst? "More like the Great Depression of this century."

If it gets really ugly, blame Wall Street and its obsession with inventing ever more complicated financial products. Mr. Narayanan is something of an expert on this. His first job out of Yale was for Smith Barney, working on earlier versions of mortgage-backed securities - mortgages that are packaged together and resold to investors.

Now, the big lenders and brokerage firms repackage almost everything this way - not just plain-vanilla mortgages but credit card debt, corporate loans, leveraged buyout debt, home loans to deadbeats who can barely fog a mirror, let alone make their payments on time. Slap 'em together, put a shiny wrapper on them, mix-and-match, give them a new name, doesn't matter what you do. Just sell them and get them off the bank's books, fast. That's the new Wall Street.

It worked, for a while. But the web of collateralized debt obligations (CDO) and mortgage-backed securities and credit default swaps and other esoterica is undermined by a fatal flaw, Mr. Narayanan reckons: "You've broken that critical link that tied the borrower to the banker." Someone lends you money to buy a house knows you and can estimate the value of the property. But a bank or a hedge fund that buys a CDO that's made up of other CDOs that are backed by subprime loans made against homes in California that have dropped 15-per-cent in value - well, how the hell can they really know what that piece of paper is worth?

"All of these credit instruments and these fancy things that Wall Street has provided these people have really been predicated on one thing, which is that markets are orderly and everything is fine," Mr. Narayanan says. And when they aren't? Then you can't sell them because there are no buyers. Ben Bernanke, the U.S. Fed chairman, estimated last week that losses on subprime loans may turn out to be $100-billion (U.S.). Mr. Narayanan's view of things is less tidy: When a real credit crunch hits - and we have not seen it yet - some banks and hedge funds won't even be able to figure out for months what their losses are on high-risk debt.

So they'll be paralyzed. And then? Lending activity dries up overnight, which leads to a U.S. recession, which brings on a global recession. "This could potentially make Long-Term Capital [whose collapse helped fuel the '98 crisis] look like some kind of walk in the park," Mr. Narayanan says.

You could easily dismiss the guy as too apocalyptic, and perhaps you'd be right. On the other hand, while your portfolio was getting savaged, his fund, which is short-selling "everything we can get our hands on" related to the U.S. lending industry, went up 10 per cent this week. If there's any truth to his doomsday predictions, this will prove to be a great time to buy gold and government bonds. And to build a bunker in your backyard.

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