Investors appear to be sobered by latest Fed interest decrease. - 2-Nov-07 - Generational Dynamics

Investors acted drunk and giddy after the September 18 interest reduction, evidently believing that the Fed had "saved the world," with the ˝% interest rate decrease. In the aftermath, investors blew the stock market bubble up larger than ever, and pushed Dow Industrials average up to a new historical all-time high on October 9.

Investors' logic the last few weeks was so bizarre that I never would have believed it possible, if I hadn't seen it for myself, and watched it unfold on CNBC:

I know from e-mail correspondence with certain people that there is absolutely no evidence that would convince them that the stock market was in a bubble, or that a bubble was even possible. Even reminding them of the Nasdaq crash in 2000 would have no effect.

But the atmosphere became distinctly different after the October 31 Fed action to lower interest rates an additional Ľ%. Many investors had hoped for another ˝% decrease, and were disappointed by just Ľ%. But that wasn't the biggest problem. The Fed also issued "guidance" that said, in effect: Don't expect any more interest rate decreases this year.

This has changed the entire atmosphere, and it was palpable on CNBC on Thursday, as worried pundits and anchors hardly knew what to expect. The Fed "safety net" was gone. No more could you hope for the Fed to bail you out if you did something stupid. The Fed made it clear that you're on your own now.

And there's plenty to worry about. Credit is getting hard to find again, not yet as bad as in the August "credit crunch," but getting closer.

The mortgage crisis appears to be accelerating, as noted in a page one article to appear in Friday's Wall Street Journal:

"The situation is now more negative than in the summer," said Pete Nolan, a portfolio manager at Smith Breeden Associates in Chapel Hill, N.C. He said that "in many cases, the fundamentals are catching up" with investors' worst fears. [chart]

The worry is that the huge financial edifice that is built on top of the now-shaky mortgage market could weaken, potentially causing lenders to tighten up on loans and slowing the economy. Besides the problems with banks and brokers, there was evidence of more problems in the mortgage market. Mortgage-servicing companies, which collect payments from borrowers, said delinquency and prepayment data were worse than expected.

"Mortgages are still deteriorating at an accelerating pace, and that's scary," said Karen Weaver, global head of securitization research at Deutsche Bank AG. "We haven't come near a stabilization, and we expect things to get worse as the bulk of resets" of interest rates on adjustable-rate mortgages "have yet to come."

The percentage of subprime mortgages -- those to home buyers with weak credit -- that were more than 60 days behind in their mortgage payments topped 20% in August, up from 18.7% in July and 17.1% in June, according to latest data from FirstAmerican Loan Performance.

Meantime, home prices in many markets have slipped. They were down more than 4% in the month of August from a year ago, as measured by the S&P/Case-Shiller index. The weaker prices have prevented some borrowers from refinancing into new loans loans, and have reduced the value of the collateral backing mortgage loans and securities.

Mark Zandi, an economist at Moody's Economy.com, estimates that of the $2.45 trillion in especially risky mortgages currently outstanding -- including subprime mortgages, interest-only mortgages, mortgages that exceed Fannie Mae lending limits and others -- as much as a quarter could suffer defaults in the months ahead. Total losses on these mortgages, he estimates, could reach $225 billion. That would hit bondholders hard, since the value of mortgage securities is driven by the performance of underlying mortgages. And it could make such bonds harder to sell in the future.

Many expect the value of homes to continue to slip as well. Mr. Zandi puts the drop at 10%, from the market's peak in the fourth quarter of 2005 to its projected bottom in the fourth quarter of 2008. That would be a decline that would wipe out more than $2 trillion in home values. That's less than the $7 trillion in stock wealth wiped out by the tech bust, but still would represent a significant hit to the economy.

Because mortgages are bundled into securities sold to investors all over the world, the deterioration in mortgages' value is having a widespread effect. Many of the more complex securities, known as collateralized debt obligations, or CDOs, are held by banks and brokerage firms. They've been the cause of much of the big losses at those institutions.

In CDOs, risk is portioned out to different groups of investors. Those willing to take the biggest risks buy securities with the highest potential returns, while investors who want more safety give up some return to get it. Already, the riskier "tranches" of CDOs have sunk dramatically in value. An index that tracks risky subprime bonds [[the ABX index]] has fallen to a record low of 17.4 cents on the dollar, down 50% from August, according to Markit Group.

That decline, while worrisome, hit investors willing to take risk. But the recent turmoil stems from declines in the market for the safest securities. Rated triple-A, they should be affected by mortgage defaults only in extreme circumstances. An index that tracks triple-A securities is trading at 79 cents on the dollar, down from roughly 95 cents just a month ago.

At the top are "super senior tranches." It is a decline in value of these supposedly safe securities that is hurting many banks and brokerage firms.

In October alone, ratings firms Moody's InvestorsService, Fitch Ratings and Standard & Poor's have downgraded or put on watch for downgrade more than $100 billion in CDOs and the mortgage securities they contain. In a glimpse of how much banks have at stake, Swiss-based UBS holds more than $20 billion of super-senior tranches of CDOs. They're among the reasons UBS, which reported a third-quarter loss of 830 million Swiss francs ($712.8 million), has warned that its investment bank is likely to face further losses in the current quarter.

"There was some widespread miscalculation when it came to estimating the credit risk and market risk of the super-senior tranches," notes Ralph Daloiso, managing director of structured finance at Natixis, a French banking group.

The large Wall Street firms weren't alone in believing triple-A-rated debt securities were safe. In the last few years, bond insurers such as MBIA Inc. and Ambac Financial Group Inc., as well as financial guaranty units of American International Group Inc., PMI Group Inc. and ACA Capital Holdings, aggressively wrote insurance on super-senior tranches of CDOs that were backed mainly by subprime mortgages. These companies effectively agreed to bear the risk of losses on these securities.

Shares of Ambac and PMI yesterday fell 19.7% and 11%, respectively, and along with MBIA hit new 52-week lows, on growing investor worry that they may need to hold more capital against the risk they are insuring and could be hit with sizable claims down the road.

Over the past two weeks, some of the insurers posted significant net losses for the third quarter due to adjustments on credit derivatives they used to provide insurance on the bonds. The bond insurers have said, however, that they don't expect actual losses from the CDO tranches they have insured."

What's so dramatic about this article is how gloomy it is -- just as gloomy as the pundits and anchors on CNBC on Thursday. This is an enormous contrast from the bubbly articles you usually encounter in WSJ and on CNBC. That's how dramatically things have changed in just a couple of days.

From the point of view of Generational Dynamics, we're headed for a major stock market panic and crash, and a new 1930s style Great Depression. The panic will be led by the Boomer Generation and Generation-X, people who have no personal memory of the 1930s, and who have no idea what's going on in the world. It's impossible to predict when this full scale panic will begin, and all we can do is which for signals of increasing panic. The current widespread change in investor mood may be such a signal, or it may not.

A web site reader has referred me to the following YouTube video, interviewing Martin Summers, the Former East European projects officer for the New Economics Foundation:

What's interesting about this video is that he discusses many of the same concepts that I do. (Do you think he's seen my web site?) My favorite quote is:

Generational Dynamics Web Log for 2-Nov-07
Investors appear to be sobered by latest Fed interest decrease.

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Generational Dynamics Web Log for 2-Nov-07 Investors appear to be sobered by latest Fed interest decrease.

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Generational Dynamics Web Log for 2-Nov-07
Investors appear to be sobered by latest Fed interest decrease.