Monday, December 10, 2007

Signs of the Economic Apocalypse, 12-10-07

From Signs of the Times:

Gold closed at 800.20 dollars an ounce Friday, up 1.4% from $789.10 at the close of the previous week. The dollar closed at 0.6822 euros Friday, down 0.2% from 0.6834 at the close of the previous Friday. That put the euro at 1.4658 dollars compared to 1.4633 the Friday before. Gold in euros would be 545.91 euros an ounce, up 1.2% from 539.26 for the week. Oil closed at 88.28 dollars a barrel Friday, down 0.5% from $88.71 at the close of the week before. Oil in euros would be 60.23 euros a barrel, down 0.6% from 60.62 for the week. The gold/oil ratio closed at 9.06 Friday, up 1.8% from 8.90 at the end of the week before. In U.S. stocks, the Dow closed at 13,625.58 Friday, up 1.9% from 13,371.72 for the week. The NASDAQ closed at 2,706.16 Friday, up 1.7% from 2,660.96 at the close of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 4.11%, up 17 basis points from 3.94 for the week.

No big movements in the markets last week. The unveiling of Bush’s plan to prevent housing foreclosures in the United States helped to counteract downward pressures on stocks. The surprise leak early last Monday of the National Intelligence Estimate (NIE) which stated that Iran’s nuclear weapons programs were disbanded in 2003 gave hope that the United States will resist pressure from Israel to attack Iran. That helped keep oil prices below their recent highs

U.S. Stocks Rise for 2nd Week on Bush Plan to Avert Recession

Elizabeth Stanton

Dec. 8 (Bloomberg) -- U.S. stocks posted their steepest two- week advance since September after President George W. Bush announced a plan to freeze some mortgage rates to prevent foreclosures from causing a recession.

Centex Corp. and D.R. Horton Inc. led homebuilders as they climbed the most in seven years. Intel Corp., Micron Technology Inc. and other semiconductor companies in the Standard & Poor's 500 Index rose the most since June following analyst predictions that demand for computers will increase. All 10 industries in the S&P 500 gained.

Stocks have rebounded after losing their 2007 gain at the end of last month, spurred by speculation the Federal Reserve will reduce interest rates to prop up the world's largest economy. The S&P 500 declined yesterday after a Labor Department report showed U.S. employers added more jobs than estimated in November, diminishing the odds that central bankers will cut their rate benchmark by half a point on Dec. 11.

“The economy is slowing, but it’s not falling off a cliff,” Jeremy Siegel, an economics professor at the University of Pennsylvania’s Wharton School of Business, said during an interview in New York. “That’s important for investors.”

The S&P 500 added 1.6 percent to 1,504.66, bringing its two- week gain to 4.4 percent and its advance this year to 6.1 percent. The Dow Jones Industrial Average rose 1.9 percent to 13,625.58. The Nasdaq Composite Index climbed 1.7 percent to 2,706.16.

Quarter-Point Cut

Ten-year Treasury yields had the first weekly gain since October, rising to 4.11 percent, as traders pared bets that the Fed will reduce its rate benchmark by more than a quarter point. Two-year yields rose to 3.10 percent.

Homebuilders in the S&P 500, which fell as much as 78 percent from their July 2005 peak through Nov. 27, added 17 percent for the steepest weekly advance since August 2000. Centex gained the most, climbing 24 percent to $25.81. D.R. Horton rose 16 percent to $13.86.

Bush announced on Dec. 6 an agreement between the government and the lending industry that would freeze rates for five years on some variable rate mortgages and provide assistance to as many as 1.2 million homeowners.

The government’s plan may help end the recession in the U.S. housing market, which is entering its third year. The number of Americans behind on their mortgage payments in the third quarter was the highest in 20 years, the Mortgage Bankers Association said Dec. 6.

‘Muddle Through’

“The economy will muddle through without tipping into recession,” said Joshua Feinman, chief economist in New York at Deutsche Asset Management, which oversees $798 billion. Growth will accelerate during the second half of next year, he said.

Intel gained the most in the Dow average, climbing 6.3 percent to $27.73. Thomas Weisel Partners LLC analyst Kevin Cassidy raised his rating on the world’s largest chipmaker to “overweight” and increased his 2008 profit estimate in part because of growing demand for computers from Brazil, Russia, India and China…

Payrolls rose by 94,000 in November, the Labor Department said yesterday. The jobless rate remained at 4.7 percent for the third month in a row. Economists predicted a gain of 80,000 jobs and an unemployment rate of 4.8 percent, according to the median estimates in a Bloomberg survey.

Sales at U.S. retailers probably rose in November as discounts and wage gains helped Americans cope with near-record fuel costs, economists said before reports this week.

“The economy from a numbers standpoint is stronger than what people’s perceptions are,” said Scott Fullman, director of investment strategy at Israel A. Englander & Co. in New York, a derivatives brokerage firm for institutional clients with combined assets under management of more than $100 billion…

Is the economy really stronger than people’s perceptions? Will the United States economy really avoid recession in 2008? Probably not. A recession is probably the best that can be expected. No doubt statistics, such as the recently released “better than forecast” employment numbers in the United States, have been massaged to make us feel better. But perception management can only go so far in masking reality.

The economy's last hurrah before that big sucking sound

Richard Benson

December 7, 2007

As 2007 wounds down, it’s time to reflect on how bogus government statistics along with Wall Street media hype have impacted the psychology and perception in the financial markets. Sheer disappointment is one way to describe what the financial markets will experience as the existing belief in a Goldilocks economy is challenged by sobering facts and a hard landing, yet to come.

Christmas is meant to be a festive and happy time of year spent with family and friends, but there is a dark side to this year’s holiday. The picture of the father, mother, son, or daughter pulling out the only credit card left that’s not maxed out in order to buy that special gift for a loved one, is not the face you’ll see portrayed in the media. The TV and newspapers show only affluent-looking preppy-faced Americans wearing pricey Italian shoes and sunglasses, shopping the malls and luxury stores for 50-inch flat screen TV’s, cashmere sweaters, Tiffany diamond rings and fancy chocolates. The media will avoid at all costs the large percentage of Americans on the brink of bankruptcy and foreclosure, living paycheck to paycheck, because there’s nothing Christmassy about that picture.

I have to wonder, though, if Americans are really shopping (i.e., spending money), or just looking for bargains at the major department stores that began running fire sales as early as October. Foreigners will undoubtedly be the luckiest group this season as they take full advantage of the declining dollar. Contrary to what you may have read in the American financial press about the declining dollar being good for America, you’ll read a different viewpoint in the foreign press, as many people overseas think America is getting what it deserves: a real comeuppance, as the dollar and our empire literally go down the tubes.

The US Economy is in terrible shape! Our government has been psychologically manipulating the American people every time they publish blatantly false data on employment and income that makes our economy look stronger than it really is. If the average American realized how bad things were, they might try to save more. But spending would collapse if they did, so the goal of the Bush Administration seems to be to hide any signs of a recession as long as possible.

If you don’t see it, it must not be there

For those familiar with the government releases, the Bureau of Labor Statistics ("BLS") just posted a benchmark data revision that showed the total number of workers employed on the payroll survey was 300,000 less than originally estimated for March 2007 (900,000 versus the 1,200,000 that was reported). By the time the dust settles, and later benchmark revisions come in for the whole year, it is likely that all of the jobs added by the BLS Birth/Death Model in 2007 will be fictitious. This could mean there hasn’t been any job growth at all! Without the fiction of job growth, you can imagine how much worse it will be for consumer income, spending, and sentiment not to mention business investment plans.

The reason employment is weak is because at least 40 percent of all job growth was tied directly or indirectly to housing. With housing in free fall, the solid job growth reported by the BLS Payroll Survey simply does not make sense.

The Department of Commerce keeps statistical estimates such as Personal Income, which is based on the estimated number of workers in the BLS Payroll Survey. So now, based on the revisions to the BLS Payroll Survey for March (and other data), revised Personal Income (wages, salaries, interest income, etc.) grew at an annual rate of only 1.6 percent in the second quarter of 2007, not the 4.5 percent originally reported. That’s three percent less in Personal Income. These imaginary workers with no Personal Income will not be shopping this December or anytime soon, so we can expect to see lower retail sales and corporate profits. Income never made, can't be spent.

As these pretend workers turn out to be a myth, they will eventually show up in the government statistics. When that happens, corporate sales will suffer and the financial markets will take notice. This is also a reminder that for statistics, the government's game is to report the false glowing numbers to the financial markets in the full light of day, and then report the corrections and horrible truth in the dead of night, and hope no one notices.

The big reason the economy is going over the cliff is not the direct result of the sub-prime mortgage debacle and the hundreds of billions in investor dollars that have been lost, although this is a major contributing factor. The reason, we focus on, is that the economy is already in recession as a direct result of homeowners having had that ATM ripped out of their house. Stories like the homeowner who purchased a home for $100,000 years ago but got carried away in the frenzy of the last decade by doing 4 cash out REFI’s, running their mortgage balance up to $625,000 while living large, are last year’s stories. That $800 billion a year in Mortgage Equity Withdrawal ("MEW") has come to a sudden end and with the average homeowner no longer living large off the house, the economy is left with that "big sucking sound".

With home prices falling, there frequently is no equity to take out! Potential borrowers don't have verifiable income to actually pay back a loan unless home prices are rising rapidly, so they can no longer buy or refinance. Meanwhile, with lenders asking for down payments, housing prices will just keep heading down for another year.

The US economy is continuing to weaken in many areas: The US Treasury has received lower income tax receipts forcing state and local governments to cut back because they’re coming up short; capital gains on home sales are falling as home prices fall; property tax receipts are also declining as assessed values go down; weak retail sales mean lower sales tax receipts; corporate profits are down, along with corporate taxes paid; and, many self-employed workers may be employed, but they’re not making anything or only half of what they used to.

Moreover, America is not the only country with an economic problem. The housing bubble is turning out to be worldwide, with a major impact on England and much of Europe. The biggest economic losers include the emerging markets, especially China. Don't believe for one second those Wall Street touts selling the notion that the emerging markets have "decoupled" from the US economy and their growth will lead the world forward without the American consumer. That’s hogwash. Where do you think their trade surpluses and big sales gains (driving investment in plants and equipment) came from anyway? From the American consumer and MEW! Take $800 billion of easy spending away from the American consumer and you're going to see a lot of blow back in lost sales by the emerging market countries, including China.

As the recession takes hold, I see this holiday shopping hype as the Economy’s Last Hurrah, but it’s not just the American economy that’s going to hear that "big sucking sound" in the New Year!

As Benson wrote above, it’s hard to imagine that a sharp downturn in the U.S. economy wouldn’t send the rest of the world into a recession as well. That has been made clear in the past few months when the world got a glimpse of how many non-U.S. banks were infected with U.S. subprime loans. But that effect will pale before what happens when the U.S. consumer runs out of money (credit).

‘Decoupling’ Debunked as U.S. Collapse Infects World

Simon Kennedy

Dec. 7 (Bloomberg) -- It turns out the U.S. economy matters after all.

The credit collapse and dollar decline that followed a surge in U.S. home foreclosures jeopardize expansions in the U.K., Canada and Germany, economists said. They also debunk “decoupling,” an argument advanced by analysts at Goldman Sachs Group Inc. and Morgan Stanley that the world wouldn’t suffer as it did during U.S. slowdowns in previous decades.

The Bank of England and Bank of Canada this week followed the Federal Reserve in cutting interest rates, and the European Central Bank lowered its growth forecast for next year. British policy makers reduced their benchmark rate yesterday, even after Governor Mervyn King expressed concern about inflation just two weeks earlier.

“Two thousand and eight will be the year of ‘recoupling’,” said Peter Berezin, an economist at Goldman in New York, explaining his firm’s about-face. “What began as a U.S.-specific shock is morphing into a global shock.”

Of the 38 countries they monitor, Goldman economists expect growth to slacken in 26 and strengthen in a dozen. That will cause global growth to slow to 4 percent next year from 4.7 percent this year, with Europe and Japan fading faster than the U.S., they say.

“There are a lot of risks out there,” Goldman Chief Economist Jim O’Neill said in an interview today.

Market lending rates have risen worldwide in the last three weeks as $70 billion of writedowns linked to defaults on U.S. subprime mortgages fanned international concern about the strength of financial institutions.

Roach Skeptical

Decoupling is “a good story, but it’s not going to work going forward,” Stephen Roach, chairman of Morgan Stanley in Asia, said in an interview in New Delhi on Dec. 2. His colleague, Stephen Jen, said in a report the previous week that because the possibility of a U.S. recession has increased, so has the chance that the rest of the world will falter.

Higher market rates pushed up the cost of lending everywhere, making it costlier for companies and consumers to fund new spending or investment. The cost of borrowing euros for three months, for example, this week rose to a seven-year high.

“Initially the impact of the subprime crisis was on the U.S. directly, but what we’re seeing now is a more insidious paralysis of credit conditions moving across different markets and economies,” said Brian Hilliard, director of economic research at Societe Generale SA in London.

Threat to Airbus

The dollar’s decline in sympathy with its economy is also exacting a price overseas. Airbus SAS may cut its 2 billion-euro ($3 billion) research budget to trim costs as the dollar’s dive becomes “life threatening” for the world’s largest planemaker, Chief Executive Officer Tom Enders said Nov. 23.

At the same time, U.S. consumers are starting to retrench in the face of declining home values and rising energy bills as oil prices near $100 a barrel. The Conference Board’s index of consumer confidence decreased last month to the lowest since the aftermath of Hurricane Katrina in 2005.

Wolseley Plc of the U.K., the world’s biggest distributor of plumbing and heating equipment, said Nov. 28 that first- quarter pretax profit through October fell almost 15 percent after U.S. revenue declined 10 percent.

“The American consumer is the big gorilla on the demand side of the global economy,” Roach said. “As the slowdown goes from housing to consumption, we’ll find the world is not as decoupled as it thinks.”

U.K. Cut

U.K. monetary policy makers yesterday cut their key rate for the first time in two years to 5.5 percent, pointing to deteriorating financial markets. In August, King said he was optimistic the turmoil wouldn’t hobble his economy.
The Bank of Canada identified “global financial market difficulties” as it lowered its main rate by a quarter point to 4.25 percent on Dec. 5.

While the European Central Bank is signaling no intention of cutting interest rates soon, Bank of France Governor Christian Noyer said Dec. 4 that there is now a “question mark” over his view of September that Europe would remain unscathed from the market rout.

Tai Hui, head of Southeast Asian economic research at Standard Chartered Bank Plc in Singapore, also doubts Asia’s economies can weather a collapse in U.S. consumer demand, with Hong Kong, Taiwan, Malaysia and Singapore at particular risk from reduced exports.

‘Need to See’

Bank of Japan Governor Toshihiko Fukui said this week that “we need to see how the U.S. consumer is affected” as he holds his key rate at 0.5 percent, the lowest among industrialized nations. Waning U.S. demand meant the Japanese economy grew an annualized 1.5 percent in the third quarter, almost half the preliminary estimate, the Cabinet Office said in Tokyo today.

On the other hand, Alex Patelis, head of international economics at Merrill Lynch & Co., is confident “the time has not yet come to call the end of this global upturn,” citing demand in emerging markets such as China and Russia.

Patelis predicts the world economy will grow 4.7 percent next year and 5.6 percent if the U.S. is excluded.

John Llewellyn, a senior economic policy adviser at Lehman Brothers Holdings Inc. in London, is unconvinced, arguing that if U.S. consumers buckle, so will growth elsewhere.

“Decoupling is a lovely idea, but I’ll only believe it when I see it,” he said.

China has the most at stake in whether or not the world economy can “decouple” from the U.S. But China itself is itself hiding huge amounts of bad debt.

The coming China crash

Martin Hutchinson

December 3, 2007

While the Chinese stock market, as measured by the China Securities Index 300, is down 18% since October 16, that follows a period of almost two years during which the CSI 300 had soared 535% since January 1, 2006. Chinese economic growth is currently running at over 11% and the big money is convinced that it will continue, while the country’s foreign exchange reserves are $1.4 trillion, the largest in the world.

A crash would appear to be imminent!

Bears on China have been common for the last decade, and their track record has not been good. To take just one unfair example, Henry Blodget, the former Internet genius, wrote in Slate in April 2005 “You’ve probably been daydreaming about the fortune to be made in Chinese stocks. Well, keep dreaming….you’ll eventually conclude that you could have done better selling insurance in Toledo.” That was about six months before the Chinese market took off, and if anybody has made 500% on their investment by selling insurance in Toledo during that period, I haven’t met him.

To see why a crash may be coming, it is worth examining the behavior of the China Investment Corporation, the $200 billion sovereign wealth fund set up by the Chinese government in September. Now $200 billion is a fair chunk of cash; you could almost buy all but three US corporations with that (at today’s prices, ExxonMobil, General Electric, Microsoft – there are 4-5 others including Google that barely top the bar.) Six weeks ago, the power of sovereign wealth funds was celebrated and China Investment’s moves into the market were awaited with bated breath.

Well, so much for that. A third of China Investment’s portfolio is to be invested in Central Huijin Investment Company, a purchaser of bad loans from the Chinese banks, and another third will recapitalize China Agricultural Bank and China Development Bank, to shape them up for privatization. $3 billion of the fund was invested in the private equity manager Blackstone in May – that may have bought China useful political contacts, but it is now worth $2 billion. And the remainder is being invested very carefully, primarily in US Treasury securities – which are also losing money steadily in yuan terms.

The lackluster investment strategy of China Investment exposes a central flaw in the Chinese economy, its lack of a rational system of capital allocation. For more than a decade, Chinese state-owned companies have made losses, and have been propped up by the banking system. Since 2004, loss-making state owned companies have been joined by overbuilding municipalities, erecting white-elephant office blocks in attempts to turn themselves into the next Shanghai. None of these losses have resulted in bankruptcy; instead the cash flow deficits have been covered by the Chinese banks. As a result, the Chinese banks have an enormous volume of bad loans -- $911 billion at May 2006, according to a later-withdrawn estimate by Ernst and Young, which must surely have ballooned to $1.2-1.3 trillion now.

That explains why China Investment is somewhat un-aggressive in its international investment strategy. China’s $1.4 trillion of reserves are in fact almost all required to prop up the banking system, when the inevitable liquidity crisis occurs. If the banks are to survive, China Investment will have to be followed by six more sovereign wealth funds of equal size, each of which will have to abandon its attempts to take over Exxon or Google and pour its money down domestic rat-holes.

A $1 trillion problem in subprime mortgages has caused even the US money market to seize up and has required frequent applications of sal volatile by the Fed. Since China’s economy is around one fifth the size of the United States’ the Chinese banking system’s bad debt problem is in real terms about five times that of the United States, about 40% of its Gross Domestic Product.

We have seen this movie before; the Japanese banking system’s bad debts after 1990 totaled around $1 trillion, about 30% of Japan’s GDP. The result was the bursting of the 1980s bubble and a period of little or no economic growth that lasted well over a decade. Admittedly the Japanese authorities made matters worse, by refusing to face up to their bad debt problem and issuing more government bonds to fund witless Keynesian public spending schemes.

Nevertheless, we can have very little confidence that the Chinese authorities, once the same problem stares them in the face, would do any better. After all, at least one of the alternative policy mixes, that tried by Herbert Hoover and the Federal Reserve in 1930-32, proved very much worse. Per Capita US Gross Domestic Product was no higher in 1940 than it had been in 1929, as in the Japanese case, but in the interval it had declined by a horrifying 28% and had recovered very slowly. If China faces the choice between a decade of stagnation, as in Japan from 1990-2003 and a decade of economic collapse, as in the United States from 1929-1940, it will rightly prefer the Japanese alternative.

It may not however have the choice. One of the factors that kept Japan out of real trouble in the 1990s was continued strong growth in the US and world economies; thus its magnificent export industries were able to continue growing, albeit at a slow rate, and provide a certain amount of traction for the economy as a whole. However, China will find it difficult to do the same, since the next decade does not seem likely to be a period of robust world growth, far from it. The United States seems fated to endure at least a few years of very sluggish growth due to its housing market crash, and Britain appears to be in a similar mess, so even relatively robust growth in the resurgent economies of Germany and Japan may not be sufficient to keep Chinese exports growing.

At that point, China will have two alternatives. It can allow the banks to work their way out of their bad loans, condemning the domestic economy to probably a decade of little growth and extremely tight credit (high Chinese savings would alleviate this problem, but they will be trapped in the Chinese banks because the authorities foolishly do not allow Chinese citizens to invest abroad.) Alternatively, it can inject more or less its entire foreign exchange reserves into the domestic banking system in order to recover its bad debts, which would allow the Chinese economy to continue expanding, but at a cost of devastatingly high inflation from the additional money pumped into the system (the $100 billion plus of Chinese bank initial public offerings carried out in 2006-07, pumped into the domestic economy, already appears to be worsening Chinese inflation and China Investment’s $130 billion will doubtless worsen the problem.)

We have seen societies with low economic growth, very high inequality (as China has now) and persistently high inflation; they are collectively known as Latin America. Since China also has much of the corruption that bedevils Latin America and its government lacks any genuine understanding of the free market and is increasingly dominated by special interests, it may indeed be fated to follow a Latin American growth path for the next few decades, with a tiny entrenched elite enriching itself at the expense of the disfranchised masses. That would be the worst possible outcome for the Chinese people, but it is not by any means impossible.

Many observers of the current US financial market downturn comfort themselves with the thought that the world now has more than one growth engine, and that China, with four times the US population, can because of its very high growth pull the world economy along sufficiently even when the US stalls. However, if China is about to incur the inevitable backlash from its recent debt and equity bubbles, during which practices have flourished that have no place in a well functioning free market, then we may be entering a world in which the two main growth engines of the last decade are both broken. Growth in such a world will be truly sluggish and inflation high, as the world struggles to cope with the effects of an excess of cheap money now grown toxic…

Those who say that the economy is better than perceptions of it are responding mostly to numbers showing how things are now. The pessimists are looking at what may be in the near future. The fundamentals haven’t changed much over the past several years, but general perceptions of the future, economic or otherwise, have gotten much more pessimistic. This is finding its way into the mainstream media. Articles like the following in the Washington Post would be hard to find a couple of years ago:

It's Not 1929, but It's the Biggest Mess Since

Steven Pearlstein

December 5, 2007

It was Charles Mackay, the 19th-century Scottish journalist, who observed that men go mad in herds but only come to their senses one by one.

We are only at the beginning of the financial world coming to its senses after the bursting of the biggest credit bubble the world has seen. Everyone seems to acknowledge now that there will be lots of mortgage foreclosures and that house prices will fall nationally for the first time since the Great Depression. Some lenders and hedge funds have failed, while some banks have taken painful write-offs and fired executives. There's even a growing recognition that a recession is over the horizon.

But let me assure you, you ain't seen nothing, yet.

What's important to understand is that, contrary to what you heard from
President Bush yesterday, this isn't just a mortgage or housing crisis. The financial giants that originated, packaged, rated and insured all those subprime mortgages were the same ones, run by the same executives, with the same fee incentives, using the same financial technologies and risk-management systems, who originated, packaged, rated and insured home-equity loans, commercial real estate loans, credit card loans and loans to finance corporate buyouts.

It is highly unlikely that these organizations did a significantly better job with those other lines of business than they did with mortgages. But the extent of those misjudgments will be revealed only once the economy has slowed, as it surely will.

At the center of this still-unfolding disaster is the Collateralized Debt Obligation, or CDO. CDOs are not new -- they were at the center of a boom and bust in manufacturing housing loans in the early 2000s. But in the past several years, the CDO market has exploded, fueling not only a mortgage boom but expansion of all manner of credit. By one estimate, the face value of outstanding CDOs is nearly $2 trillion.

But let's begin with the mortgage-backed CDO.

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

It was a marvelous piece of financial alchemy, one that made Wall Street banks and the ratings agencies billions of dollars in fees. And because so much borrowed money was used -- in buying the original mortgages, buying the tranches for the CDOs and then in buying the tranches of the CDOs -- the whole thing was so highly leveraged that the returns, at least on paper, were very attractive. No wonder they were snatched up by British hedge funds, German savings banks, oil-rich Norwegian villages and Florida pension funds.

What we know now, of course, is that the investment banks and ratings agencies underestimated the risk that mortgage defaults would rise so dramatically that even AAA investments could lose their value.

One analysis, by Eidesis Capital, a fund specializing in CDOs, estimates that, of the CDOs issued during the peak years of 2006 and 2007, investors in all but the AAA tranches will lose all their money, and even those will suffer losses of 6 to 31 percent.

And looking across the sector, J.P. Morgan's CDO analysts estimate that there will be at least $300 billion in eventual credit losses, the bulk of which is still hidden from public view. That includes at least $30 billion in additional write-downs at major banks and investment houses, and much more at hedge funds that, for the most part, remain in a state of denial.

As part of the unwinding process, the rating agencies are in the midst of a massive and embarrassing downgrading process that will force many banks, pension funds and money market funds to sell their CDO holdings into a market so bereft of buyers that, in one recent transaction, a desperate E-Trade was able to get only 27 cents on the dollar for its highly rated portfolio.

Meanwhile, banks that are forced to hold on to their CDO assets will be required to set aside much more of their own capital as a financial cushion. That will sharply reduce the money they have available for making new loans.

And it doesn't stop there. CDO losses now threaten the AAA ratings of a number of insurance companies that bought CDO paper or insured against CDO losses. And because some of those insurers also have provided insurance to investors in tax-exempt bonds, states and municipalities have decided to pull back on new bond offerings because investors have become skittish.

If all this sounds like a financial house of cards, that's because it is. And it is about to come crashing down, with serious consequences not only for banks and investors but for the economy as a whole.

That's not just my opinion. It's why banks are husbanding their cash and why the outstanding stock of bank loans and commercial paper is shrinking dramatically.

It is why Treasury officials are working overtime on schemes to stem the tide of mortgage foreclosures and provide a new vehicle to buy up CDO assets.

It's why state and federal budget officials are anticipating sharp decreases in tax revenue next year.

And it is why the Federal Reserve is now willing to toss aside concerns about inflation, the dollar and bailing out Wall Street, and move aggressively to cut interest rates and pump additional funds directly into the banking system.

This may not be 1929. But it's a good bet that it's way more serious than the junk bond crisis of 1987, the S&L crisis of 1990 or the bursting of the tech bubble in 2001.

The fact that pessimistic talk is featured in the leading news outlets in the United States may be the best evidence that the plug is being pulled.

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