In the Weeds

The bears are red in the claw and they are having their day. The Dow hasn’t closed below 12000 since November 3, 2006, Fox Business’s stats pro Charles Brady informs us, and it hasn’t fallen below 12000 since March 14, 2007 on an intraday basis.

Some armchair cranks now claim they saw it coming. They say they saw the weakness move from the homebuilders in 2005 to the community and regional banks in 2006 into 2007, to the consumer this past holiday season, and now to a weakening labor market.

Yes, 20-20 hindsight is a beautiful thing. And yes if you call a recession long enough you can call yourself a seer. Because for me, I like to say that the epitaph on my tombstone will read, “I’m in it for the long-term.” There are a lot of value plays still out there, more on that in ensuing blogs (I gotta get you to come back and visit me, right?).

First the uglies. We’re in a credit crisis like no other, different from the S&L crunch of 1989-1992, though with some similarities. That crisis started with a pullback in lending for commercial real estate that then spread to business lending. Back then commercial loans that went bellyup were not too opaque.

Right now we’re dealing with a credit crisis fueled by Frankenstein mortgage derivatives spun out from the housing crisis, securities that have both Ben Bernanke and Alan Greenspan scratching their heads. What happened? When Freddie Mac and Fannie Mae were limited in the dollar amount of mortgages they could buy and securitize, to $417,000, Wall Street stepped in to securitize these loans. Wall Street, in case you didn't know it, is in manufacturing too.

It manufactured all sorts of subprime paper, paid the credit ratings agencies more money than the usual fees paid on corporate bonds to get rosy ratings, sold this paper to all sorts of unwitting investors here, including pension funds and local governments, and started exporting this bad paper to any takers overseas. Wall Street firms then kept a sizable slug of this bad paper off their balance sheets to keep financial results rosy, and then wrote themselves sweet bonus checks off the goosed-up numbers.

Any bear worth his or her claws knows that as far back as 1987 the accounting monks of Norwalk, Conn. at the Financial Accounting Standards Board warned there was no adequate way to value these things, and now Frankenstein derivatives are sluicing financial poison through the system. Citi’s chief financial officer, Gary Crittenden has said that price-tagging CDOs “all gets extremely complex” and that “it is very difficult to forecast exactly where all this is going.”

It’s that uncertainty over how to value these securities and over when housing will find its bottom that’s fueling the jitters. Remember, we’ve seen uncertainty exact damage before. Students of the 1987 crash—painful to cite but it does hold lessons—remember that what really triggered the panic selling that awful day in October was uncertainty that led to panic selling, triggered by a breakdown in the basically paper system used to place stock trades. The system cracked under the weight of requested trades that were three times the level on any ordinary day. A government-backed commission later found that orders for 112 million shares were never executed—more than one-fourth of the total value of trades that day. The shutdown triggered a stampede for the exits.

It's uncertainty that's hurting us now. What investors need now is evidence that the write-offs in the financial-services sector are behind us, that housing has seen its bottom. Merrill Lynch says housing will decline 30% over the next three years, still nothing versus the 130% runup in prices from 2003 and 2006. Phew.

We may see some daylight about writedowns in the second quarter, around when the auditors are done scrubbing the books (and they're being extra tough, what with the Arthur Andersen debacle still fresh on their minds). We’ve already seen $107 billion in writedowns at the financials. With further drops in housing values, writedowns could be with us for some time.

Plus the downgrade of bond insurers is surely helping fuel the rocky markets now. When a bond insurer gets downgraded, the value of the insured debt securities at the financials also drop in value too, so they have to hoard even more cash beyond the capital they're grabbing to plug the holes in their leaky balance sheets (and remember, some like Citi are bringing back onto the books off-balance sheet debt they didn't reserve for, making that hole bigger). On top of all this, credit cards and home equity loans are creating problems, too.

But consider this: Some of the uncertainty over what these credit-backed securities are worth may be exaggerated. Much of the downward suction of uncertainty arises from a self-fulfilling prophecy intrinsic to how Wall Street values the Frankenstein securities it breathed life into. The G-forces of uncertainty over what these mortgage securities are really worth are exerting a Black hole-like force now.

Remember that there is no standard way to value these hard-to-read securities down on Wall Street, something I’ve already said the Securities & Exchange Commission must address now. The fire-engine red alarms should be ringing at SEC headquarters in Washington, D.C.

So watch what happens. Many banks rely heavily on something called the ABX index to mark to market (or value) many of these illiquid assets. The credit ratings agencies use the ABX too. The ABX is an index largely based--now this is important to remember--investor sentiment. The ABX is a thinly traded, volatile index invented just two years or so ago and is a series of credit-default swaps based on 20 bonds that consist of subprime mortgages. ABX contracts are commonly used by investors to speculate on or to hedge against the risk that the underling mortgage securities are not repaid as anticipated. The ABX swaps offer protection if the securities are not repaid as expected, in return for regular insurance-like premiums. A drop in the ABX Index indicates investor sentiment that subprime mortgage holders will suffer increased losses from those securities. Similarly, an increase in the ABX Index signifies investor sentiment that subprime securities will improve in value.

Some critics rightfully argue that the ABX is a very narrow window on the mortgage market and, because it is so thinly traded, is highly vulnerable to a few large trades to the downside. About $3 billion to $4 billion of trades take place in the ABX each day. That’s versus $179 billion in average daily trading volume in S&P 500 index futures and options contracts on the Chicago Mercantile Exchange.

But the Wall Streeters who post the trades affecting the ABX try to anticipate what the credit ratings agencies will do rating these asset-backed securities and place bets in the ABX accordingly. However, the credit ratings agencies watch what the ABX is doing to decide whether to downgrade securities. The banks in turn watch the credit ratings agencies and what the ABX is doing.

The echo chamber is amplifying at dangerously loud levels, as everyone is watching each other.

Wachovia Capital Markets has already said that the price of the ABX that tracks AAA-rated mortgage debt has implied losses of around 49% among pools of subprime mortgages issued in 2006. You only get to a cumulative loss of 49% if all, count them, all of the 2006 subprime mortgages issued that year were to go bellyup, and only half of their value after foreclosing on the homes were recovered. Or if half were to default and recover nothing. That’s what we’re looking at. Sounds a bit out there, but unfortunately. we’ll have to wait and see.