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Generational Dynamics Web Log for 4-Aug-07
Stock markets continue fall as subprime "contagion" spreads

Web Log - August, 2007

Stock markets continue fall as subprime "contagion" spreads

The Dow Industrials fell almost 300 points on Friday on a steady stream of bad news.

The immediate trigger appears to have been an admission by chief financial officer that the US credit markets were the worst in decades. "These times are pretty significant," he said on a telephone conference call with investors. "I've been out here for 22 years, and this is as bad as I've seen it in the fixed-income markets."

Bear Stearns, which now has two worthless hedge funds and a third one in trouble, had its rating downgraded by S&P from "stable" to "negative." The conference call was meant to calm jitters, but it did the opposite, as it was the perceived trigger for an additional 200 point drop on Friday afternoon.

American Home Mortgage, whose stock fell 90% on Tuesday has laid off 7,000 workers and is now expected to file for bankruptcy. Chief executive Michael Strauss said: "Unfortunately, the market conditions in both the secondary mortgage market as well as the national real estate market have deteriorated to the point that we have no realistic alternative."

Pundit David Johnson on PBS Marketplace on Friday said, "This has been a bizarre week that at no point felt good. It's the subprime stuff. This has the potential to be much wider spread than just the housing market -- deals that won't get funded -- the solvency of the big financial companies - the Lehman Brothers and the Goldman Sach's and Bear Stearns -- all those stocks have been killed in last couple of days. ... We don't know how bad things are. You don't know -- how many hedge funds are in trouble, if it will have an impact on the average joe - how heavily impacted the housing market is, and whether the Fed's gonna have to walk in and do somehting. It's the uncertainty that drives you up a tree. ...How many times gave you seen the stock market do 2 billion shares a day in the summertime? Everyone's supposed to be on vacation."

That's the way things are going as investors are close to panic -- fearing a big "correction" that cause the market to fall before they got out, but also fearing a rally that could catch them barefoot out of the market.

The worry is about "contagion." At first, only a tiny portion of the housing market was going to be affected, the subprime mortgage market. But now it's clear that the "contagion" has spread to Alt-A mortgage loans and even the least risky mortgages. The reason has nothing to do with the mortgage loans themselves: If your home is worth significantly less than the amount of your mortgage loan, then you have nothing to lose by just walking away and defaulting on your mortgage.

Next, as Bob Johnson's remarks indicate, the "contagion" may have spread to the big financial firms. How many of them will go under?

A pundit on CNBC on Friday afternoon -- I didn't catch his name -- made a very interesting point. He said that many banks and financial institutions are heavily invested in mortgage-based securities, but they don't want to even investigate it, because to do so would create a market in these securities, and then by mark-to-market rules, more portfolios would have to be revalued.

In other words, other financial institutions are doing a cover-up for exactly the same reason that Bear Stearns covered-up its asset values in June. The cover-up didn't last long, of course, as the firm soon had to announce that its hedge funds are worthless. According to this pundit, there are other financial institutions doing exactly the same thing.

Index price of low-quality ABX-HE-BBB- 07-1 credit derivatives and high-quality ABX-HE-AAA 07-1 credit derivatives from Jan 19 to Aug 3, 2007 <font face=Arial size=-2>(Source: Markit.com)</font>

Index price of low-quality ABX-HE-BBB- 07-1 credit derivatives and high-quality ABX-HE-AAA 07-1 credit derivatives from Jan 19 to Aug 3, 2007 (Source: Markit.com)

This certainly wouldn't be a surprise, since all these institutions wanted to get in on the gravy train when liquidity was flying high. In fact, banks around the world invested in these termite-infested securities.

The graphic has the latest values of the ABX index for low-quality and high-quality credit derivative securities. As you can see, these indexes are in free fall, and it makes no difference whether you're talking about subprime mortgages or high-quality mortgages.

What this graph does is that it serves as a proxy for the values of securities portfolios in banks that invested in mortgage derivatives -- and that's most of them.

This past week, for example, two major German firms announced that their hedge funds are in trouble.

The Europeans, of course, are hoping and praying and hoping and praying that the "subprime contagion" won't reach them.

This brings me to the words of Neil Munroe of Equifax in Europe, speaking on the BBC on Friday morning (ET). According to him, things are bad in the US, but the Europeans have been much more prudent and controlled:

"I think the problem is contained in the US because of the activity. I think in other parts of Europe there is a much, much stricter regime about some of the underwriting criteria that people can use. There is more control.

In the UK there's the FSA, and in Germany and other countries, there are similar organizations that will be controlling that. There's more prudence here I think. There's more respect. ..

I think there's going to be a couple of weeks where [the market is] going to be a bit sensitive. I think it will [stabilize]. I think it has to [stabilize]. I think people will realize that it's an isolated incident, albeit a very big one in the US. I think that when people understand that this is a global funding issue, and not a consumer issue, then I think the market will settle."

I've only quoted a few paragraphs out of this guy's interview, but I noticed one interesting thing. At the start of the interview, he was speaking very slowly and confidently. By the end of the interview, he was speaking faster, his voice had a higher pitch, and, if you look at the last paragraph, he was beginning every sentence with "I think." This guy is one nervous nellie.

And well he should be. We mentioned the German hedge funds above, but that isn't the main problem. Recall what I wrote in July 2004, in an article entitled, "Real estate is in an overpriced bubble all over the world": "Residential properties in countries around the world, including America, Australia, the United Kingdom, China, South Korea, Spain, the Netherlands, and South Africa, are overpriced by 50% or more."

You have the same situation around the world: A housing bubble that's bursting; and banks and financial organizations heavily invested in collateralized debt obligations (CDOs) whose values are based on the graphic shown above.

You should understand this, dear reader, if you don't understand it yet: This is going on right now. And I'm not making any of this stuff up. The values of securities in the portfolios of mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, are already crashing. That's what the above graph shows.

The panic has already begun, even if "the contagion" hasn't yet hit the stock market. But if Bear Stearns alone could trigger a stock market fall, then imagine what will happen when a number of other institutions are forced to revalue their portfolios by mark-to-market rules, something that they're desperately trying to avoid now, in the hope that the market will move back into super-bubble territory again.

What should you expect in the next few weeks?

An online correspondent has reminded me that in past major stock market crashes, the market fell 10-20% before the real crash occurred.

Assuming that history repeats itself, the Dow will fall to around 11,000-12,000. If a crash is going to occur now, it will occur around that time, in a few weeks. If you'd like to analyze this some more, take a look at the article that I wrote last year, "Speculations about a stock market panic and crash"

From the point of view of Generational Dynamics, it's always impossible to make short-term predictions. What we know is this: A generational stock market crisis is overdue (the last one was in 1929), but we don't know for certain whether it will occur next week, next month, next year, or even later.

However, we also know that we're seeing a pattern that's typical of immediate pre-crash periods. Now, I've been fooled before, so nothing is certain. But with the incredible collapse of the ABX index, and the knowledge that more and more lenders are "imploding" every week, there is reason to believe (but not certainty) that the crash has already begun slowly and the fall is accelerating. (4-Aug-07) Permanent Link
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Generational Dynamics Web Log for 4-Aug-07 Stock markets continue fall as subprime "contagion" spreads

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Generational Dynamics Web Log for 4-Aug-07
Stock markets continue fall as subprime "contagion" spreads