Totally Discredited S&P

On 2007-07-31 American Home Mortgage went under. After receiving multiple margin calls, it simply ran out of cash. Bear in mind that just a couple weeks ago it "reaffirmed" its $.70 dividend. Today it was lights out. The stock was halted on Monday and sank 90% when trading resumed today. See Liquidity Crunch at American Home and Unable to Borrow for a recap.

Dave Donhoff at No Bull Mortgage sent me the following earlier today.

AHM/ABC Kapputt
From our clearing firm's office this AM;
Subject: Notice: American Brokers Conduit closes it's doors

Our office received a phone call this morning from the Operations Manager of American Brokers Conduit in Las Vegas, Nevada. They have ceased doing business as of this morning. They have no money for wires on loans that have already signed loan docs. Please contact our Rep, Sanja and she will see that your files are returned to you so you can place your loans with other lenders.

Dave posted this comment on The Market Traders: "This is significant as the first MAJOR A-paper mortgage bank, with significant volume and a huge brokerage base, to go belly up."

AHM is out of money and out of business. It's the end of the line for American Home Mortgage. Judging from insider sales, it seems only one insider, John A. Johnston (president Western Division) saw this coming and bailed. A few of the losses are staggering.

Absurdity at the S&P

The S&P is sure right on top of things as this 3:42 PM headline shows: S&P Puts AHM Rankings on Negative Watch. Wow. What a bold, stunning, and timely move by the S&P. Let's take a look.

Standard & Poor's Ratings Services on Tuesday placed its "average" residential prime ranking for American Home Mortgage Investment Corp. on credit watch with negative implications.

The ratings agency also removed the home lender from its "select servicer list."

S&P believes the company's financial troubles could result in higher turnover in its servicing operation and hurt servicing performance.

How clever of the S&P to figure out that a company that has stopped doing business might experience "higher turnover in its servicing operation and hurt servicing performance". That is simply stunning analysis. Who else could have figured that out?

Now that American Home Mortgage has ceased doing business, I suppose it's safe for the S&P to remove AHM from its "select servicer list". Does (or did) the S&P have a relationship with AHM and if so what was the nature of it? (I don't know, I'm simply asking).

Rating Company Disclosures

• Moody's: "Moody's has no obligation to perform, and does not perform, due diligence."
• S&P: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

In Fitch Discloses Its Fatally Flawed Rating Model I asked a series of questions and still have no answers. Here they are again.

Questions To Ponder

• How many billions of dollars will be lost because of absurd pricing models?
• How can it be that an entire system of investment decisions are based on ratings that the ratings companies tell everyone not to use for investment purposes?
• Were the ratings companies grossly incompetent or just foolish?
• Will the disclaimers of the ratings companies hold up in court?
• How long will it be before there be a court test of those disclaimers?
• Why has only a minuscule portion of subprime debt (2.1% or $12 billion of a massive $565.3 billion of subprime bonds) downgraded. See Stress Test.
• Are the ratings companies under pressure by the banks and/or the Fed to not rerate this debt?
• Why is it that ratings companies are allowed to have outside business relationships with the companies whose debt they rate?
• Did banks realize how absurd those ratings were but look away because of greed and the ease in offloading he debt to pension plans, insurance companies, and hedge funds out of pure greed?
• Heck, did the upper echelons at the ratings companies themselves know their ratings model was flawed and look the other way out of greed?
• How long before there is a government sponsored bailout of this mess? Hint small ones are starting already. See Please - No More Help! for a discussion.
• How long before Bernanke starts cutting rates?
• How high will gold prices rise when Bernanke starts cutting?
  

Here's the big question:
How big will the taxpayer bailout be?

Running Scared

Forbes has an interesting article out today called Running Scared.

On a day when another mortgage lender, American Home Mortgage, teetered toward liquidation, Standard & Poor's said the U.S. corporate bond market was officially speculative grade.

The big ratings agency said 50.7% of the corporate bond market is now rated speculative grade, the first time this has happened, marking a decade-long shift toward more aggressive finance strategies and the evolution of the leveraged finance market. S&P calls anything below BBB- "speculative," but most people just call it junk. These days, the market calls it scary.

S&P said the ratings mix of corporate bonds continues to deteriorate as firms borrow to buy back shares and make acquisitions, but the key factor to the deterioration is simply the sheer number of lower-rated bonds coming to market. Through the first half of 2007, 70% of 158 new issues were rated B, according to S&P research.

"It would not be surprising to see even more new speculative-grade entrants this year," wrote Diane Vazza, S&P's managing director of fixed-income research, in a note Tuesday. "Though firms may have to curtail leverage" to find buyers.

Without a doubt the S&P has made many huge mistakes recently in rating debt associated with mortgages. The models Moody's, Fitch, and the S&P used to rate mortgage debt are now thoroughly discredited. Worse yet is the fact that everyone of the rating companies refuse to downgrade all but 2%-3% of the worst mortgage debt. And putting American Home Mortgage on credit watch after it ceased business can only be considered bizarre.

The S&P says 50.7% of the corporate bond market is now rated speculative grade. What the S&P does not say is how much of the debt that is not rated speculative should be rated speculative. What the S&P also does not say is how much of the total debt it has rated is over rated.

According to Bloomberg "Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold." The S&P is so freaking behind the curve in debt downgrades that a company has to cease doing business before being removed from its "select servicer list". So exactly who (and why) would anyone have any confidence in the S&P's ratings of damn near anything?

But whether or not the S&P, Moody's, or Fitch has the nerve to act, the credit markets won't sand still. American Home Mortgage sure proved that with a stunning 90% drop overnight.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

One Speech Two Interpretations

In Unable to Borrow I mentioned a speech by the Fed's Poole. Minutes later a second version of the same story hit the news. Here are the headlines and stories.

From MarketWatch

Fed won't ride to rescue of upset markets: Poole
Last Update: 1:30 PM ET Jul 31, 2007

Financial markets understand that the Federal Reserve will not respond quickly to a typical financial market upset such as last week's sharp stock sell off, said St. Louis Fed President William Poole on Tuesday. Poole said the best policy for the Fed in cases of market turmoil is to be cautious and try to understand the reasons for the volatility. The Fed should only act "in due time" if evidence accumulates that the market upsets threaten to cause price stability or low unemployment, or when financial-market developments threaten market processes themselves, Poole said. "If the market believes that the Fed is always primed to adjust policy, then market participants will spend more time trying to second guess the Fed than trying to understand what is happening to business and household behavior," Poole said in a speech prepared for delivery at the University of Missouri.

From Reuters (14 minutes later)
Fed will act on market slide if warranted: Poole
Tuesday July 31, 1:44 pm ET

The U.S. central bank is still examining the impact of last week's stock market slide, but would act if this threatened its goals for inflation or employment, a top Federal Reserve official said on Tuesday. Poole said the Fed should not add to the uncertainty by making its own policy less predictable. But if it was convinced about the scale of the risks, it would not stand idle.

"The market understands, I believe, that the Fed will act in due time if and when evidence accumulates that action would be appropriate," he said.

"Most of these upsets stabilize on their own, but some do not. I'm not saying that the Fed should ignore what happened last week - we need to understand what is happening," he said.

Poole also said the decline in long-term interest rates last week as investors sought the sanctuary of U.S. Treasury bonds had helped to stabilize financial markets. He said that this was thanks to well-anchored inflation expectations.

What a difference reporting makes. Here is the key sentence:
"The market understands, I believe, that the Fed will act in due time if and when evidence accumulates that action would be appropriate," he said.

Essentially the Fed views a falling market as a threat. Of course a rising market, no matter how reckless or speculative is not a threat. Such is the nature of the misguided policies of the Fed that constantly blows bigger and bigger bubbles to cover up its own mistakes.

To top it off there is enormous hubris by Poole to think the Fed can control the market. See Can the Fed control prices? for a discussion of how the Fed is not really in control of prices or anything else.

Meanwhile another Bear Stearns hedge fund is in trouble.

15:22 *BEAR STEARNS FACES LOSSES FROM THIRD HEDGE FUND, WSJ SAYS
15:22 *BEAR STEARNS FUND HAS $900M IN MORTGAGE INVESTMENTS, WSJ SAYS
15:28 *BEAR STEARNS HALTS REDEMPTIONS ON ABS FUND, SPOKESMAN SAYS
15:28 *BEAR STEARNS FUND HAS $900M OF ASSETS UNDER MANAGEMENT
15:29 *BEAR STEARNS SAYS SUBPRIME LESS THAN 1% OF HEDGE FUND ASSETS
15:29 *BEAR STEARNS SPOKESMAN SAYS HEDGE FUND HAS NO DEBT
15:30 *BEAR STEARNS SPOKESMAN SPEAKS IN TELEPHONE INTERVIEW
15:31 *BEAR STEARNS SAYS HEDGE FUND REDEMPTION REQUESTS ROSE IN JULY

Six Questions

• Want to stop serial bubble blowing?
• Want to get rid of the Fed and its misguided policies?
• Want to get rid of the IRS?
• Want to restore sound monetary policies?
• Want to restore sound fiscal policies?
• Want a currency backed by gold as the constitution says?

One Answer

Vote for Ron Paul.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Unable to Borrow

Reuters is reporting American Home Mortgage unable to borrow.

American Home Mortgage Investment Corp., (AHM) a mortgage lender, said that it is unable to borrow under its bank lines and is looking at ways to raise money, including "the orderly liquidation of its assets."

The company said it has retained Milestone Advisors and Lazard to help it evaluate its strategic options.

MarketWatch is reporting American Home Mortgage Working To Resolve Liquidity Issues.

American Home Mortgage Investment Corp. (AHM) said Tuesday it is trying to resolve liquidity issues, which it said arose from disruptions in the secondary mortgage market. The Melville, N.Y., mortgage real-estate investment trust said Tuesday that lenders have initiated margin calls in response to the declining collateral value of certain loans and securities in its portfolio. American Home Mortgage has received and paid significant margin calls in the last three weeks and has substantial unpaid margin calls pending, the company said. The company said that, at present, it can't borrow on its credit facilities and couldn't fund its lending obligations Monday of about $300 million. It doesn't anticipate being able to fund about $450 million to $500 million Tuesday

Q: What happens when you are unable to borrow and can't fund margin calls and other obligations?
A: Something like this (except divided by 10) ...



AHM is currently sitting at a $1.10 (but changing rapidly now) having hit a low of $1.06, down 90% (overnight) from already depressed levels.

Obviously another chapter in the Liquidity Crunch at American Home is being written today. Eventually someone will buy them out at pennies on the dollar but the final chapter will no doubt be massive numbers of lawsuits.

No Poole Party

Earlier today Fed member Poole said Fed won't ride to rescue of upset markets.

Financial markets understand that the Federal Reserve will not respond quickly to a typical financial market upset such as last week's sharp stock sell off, said St. Louis Fed President William Poole on Tuesday. Poole said the best policy for the Fed in cases of market turmoil is to be cautious and try to understand the reasons for the volatility. The Fed should only act "in due time" if evidence accumulates that the market upsets threaten to cause price stability or low unemployment, or when financial-market developments threaten market processes themselves, Poole said. "If the market believes that the Fed is always primed to adjust policy, then market participants will spend more time trying to second guess the Fed than trying to understand what is happening to business and household behavior," Poole said in a speech prepared for delivery at the University of Missouri.

There is no such thing as "In Due Time". The Fed should not attempt to bail out the market place, ever, period. It is the repeated intervention over the years (otherwise known as the "Greenspan Put") that puts an unnatural bid on the market and promotes speculative behavior.

The foreclosures and the housing related blowups we see now are a direct result of the last party. The Fed managed to bailout lenders in the wake of a dotcom bust by slashing rates to 1%. What's next? I suggest the biggest party has already been thrown. There is no conceivable bailout coming that is going to create jobs and encourage reckless spending like housing did. It's the end of the line.

Today Poole says "No Party ... yet". What the Fed doesn't know is that few will be willing to put on those party hats when they next attempt to pass them out. Banks wont lend to poor credit risks and good credit risks will have no reason to borrow in a world awash in overcapacity. Cheap labor enhances the problem and will make it impossible for many consumers to pay back debts.

The party is over but a massive hangover is just starting.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Massive Bets On Idiots

CNN Money is reporting Fund manager's fun sailing away.

Hedge fund manager [John Devaney] whose fund ran into trouble from the sell-off in securities backed by subprime mortgages is having to put his huge yacht up for sale, seeking $23.5 million.

John Devaney, the CEO of United Capital Markets, a fund that specializes in buying and selling bonds that are backed by the mortgage payments, particularly adjustable rate subprime mortgages, has put his 142-foot yacht "Positive Carry" up for sale, according to a yacht broker's Web site.

Devaney's fund has run into trouble lately. A spokesman for the firm told Reuters on July 3 that it had stopped honoring request from some of its investors for redemptions, or withdrawal, of investments.

Devaney told Money magazine this spring that despite problems that the loans cause for borrowers, the assets backed by them provided a good return for his fund.

"The consumer has to be an idiot to take on those loans," he said. "But it has been one of our best-performing investments."

But with rising delinquency and default rates in the sector, investors have been scared away from the assets lately, hitting those like Devaney who made a big bet on the investment.

According to the yacht broker's listing, the yacht has accommodations for 10 passengers in its five staterooms, along with space for a crew of seven. Its amenities include his and her baths in the master suite, and four guest bathrooms with Jacuzzi tubs and showers and cherry wood interior throughout.

It has two 2,250-horsepower engines and a range of 3,500 nautical miles.

The New York Post reported Monday that Devaney is also seeking to sell a home in Aspen for $16.5 million.

Pure Arrogance

On 2007-05-02 Devaney spoke with CNN Money about How to get rich trading "idiot" loans.

The housing boom was good to John Devaney. Really good. He owns a Rolls-Royce, a Gulfstream Jet, a 12,000-square-foot mansion in Key Biscayne and a 143-foot yacht, as well as a few Renoirs and a valuable 1823 reproduction of the Declaration of Independence.

Devaney's not a developer, and he's certainly not a flipper. The 36-year-old CEO of United Capital Markets is a bond trader. And one of his specialties is buying and selling bonds that are backed by the mortgage payments of ordinary homeowners.

Option ARMs? Devaney loves 'em. "The consumer has to be an idiot to take on those loans," he says. "But it has been one of our best-performing investments."

"Some of the investors who bought CDOs certainly took on more risk than they thought," says John Weicher, a former assistant secretary of housing now at the Hudson Institute. But Devaney, who told a crowd of investors that the riskiest mortgage bonds looked "awful" before the crash, says he thinks he'll be buying. "I don't believe the carnage and fallout will be as bad as people think," he says.

Whether or not big investors come out okay, the damage is done for many homeowners. "The system allowed banks to create unsustainable loans that are going to haunt borrowers for years to come," says Allen Fishbein, director of credit and housing policy at the Consumer Federation of America. "Unlike the bank, the borrower has no way to lay off the risk."

Indeed "the damage is done". In more ways than one. Not only was he willing to bet on "idiots" willing to buy houses at ever absurd prices he was willing to roll the dice with OPM (other people's money) with that idea on his hedge fund. Why not? Hedge funds collects 20% of the profits and suffer 0% of the losses when they blow up.

Devaney, like Bear Stearns (whose High-Grade Structured Credit Strategies Enhanced Leverage Fund went to zero) has locked in investors and has stopped redemptions.

Devaney did NOT say this, but he may as well have: "You have to be an idiot to knowingly invest in a hedge fund that admittedly makes money by betting on the behavior of other idiots (with leverage), knowing full well that one or the other or both idiots is bound to blow up".

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Liquidity Crunch at American Home (a complete recap)

Brian McAuley, my partner at Sitka Pacific Capital Management tells me that "things always happen when I am on the road". They sure did last week while I was in Vancouver for an Agora sponsored wealth symposium called "Rim of Fire".

The conference was about Crisis and Opportunity in the New Asian Era. It was a fantastic conference with speakers including Bill Bonner, Rick Rule, Nassim Taleb (author of The Black Swan) Frank Trotter (president of Everbank), Richard "Mogambo Guru" Daughty, James Kunstler, Paul Van Eden, Agora newsletter writers, and many more. A multitude of commodity oriented vendors were there (energy, base metals, gold, silver, nickel, uranium, copper, alternative energy). It was a fantastic conference and if you get a chance to go next year I think it would be worth your while to do so. Obviously my association with Agora makes my opinion somewhat biased but I am not getting anything per se for putting in this plug, nor was I asked to do it by Agora or anyone else.

With the conference going on, and not wanting to miss any sessions, it was a struggle trying to keep up with commenting on all the news about canceled IPOs, the falling stock market and other things. Saturday was a travel day and it was not until late Saturday evening that I saw what could be one of the stories of the year: a Liquidity Crunch at American Home Mortgage. This story had been brewing for a long time. And it worsened again this weekend, dramatically. Let's recap.

Recap of American Home Mortgage Woes

2007-06-29

Roof Caves In For American Home Mortgage

American Home Mortgage announced missed payments on loans will lead to a big second quarter loss just as concerns escalate that defaulting mortgages could roil the economy. Shares of American Home Mortgage (AHM) plummeted 2.51, or 12.0%, to $18.40, after the company yanked its second quarter guidance. American Home said "substantial" charges will push the company to a second quarter loss. Analysts were expecting earnings per share of 75 cents.

2007-07-19

AHM Plunges On Rumor Credit Line Yanked

American Home Mortgage Investment shares plunged 21% Thursday on rumors that a large lender had withdrawn a credit line. Keefe, Bruyette & Woods analyst Bose George said that the rumor circulating was that Lehman Brothers had pulled the company’s credit line, however, George said American Home doesn’t receive a credit line from Lehman Brothers and that American Home’s chief financial officer had denied the rumor.

Nonetheless, shares of the Melville, N.Y.-based company plunged 20.8%, or $2.83, to $10.76 at the close on Thursday, although it gained 3.2% in after-hours trading.

2007-07-20
American Home Mortgage Back On Track?

Talk about a rebound! Although American Home Mortgage Investment hasn’t recovered all of the value it lost when the stock plunged on Thursday following a rumor that Lehman Brothers had yanked its credit line, it has certainly made up lost ground.

Another boost to American Homes shares may have been a research note put out by RBC Capital Markets analyst James Ackor saying the stock tumbled on Thursday well below its value. While investors fear the investment banks that lend the company money might withdraw their credit lines, Ackor said he doesn’t believe they will.

2007-07-20
American Home Mortgage Holdings "outperform," target price raised

Analysts at RBC Capital Markets maintain their "outperform" rating on American Home Mortgage Holdings, while reducing their estimates for the company. The target price has been raised from $20 to $25.

2007-07-25
American Home Mortgage Plunge is Portfolio-Management Lesson

Thursday's selloff was evidently triggered by speculation the company was being denied access to short-term lines of credit, the lifeblood of a mortgage lender. When I contacted AHM, a spokeswoman said no credit line had been pulled. Apart from the speculation, there's little to explain why AHM stock has been punished so severely. Some bargain hunters stepped in Friday, and on the face of it, the stock screams "buy." The dividend yield is 22%, and the P/E is 7.7.

In June, AHM forecast a second-quarter loss and withdrew guidance for the year, but reaffirmed its dividend of 70 cents a share. It attributed the shortfall to rising delinquencies on mortgages it issued, a reduced demand for the mortgages it packages and sells to investors, and losses on loans it had to buy back under warranties extended to buyers. But it said these trends were stabilizing and had shown some improvement.

My initial recommendation was based on the good reputation of the company's management, its excellent liquidity and its lack of exposure to the subprime crisis. None of that has changed. But what started as a subprime-mortgage crisis is working its way through the financial system in some unexpected and unpredictable ways.

2007-07-26

AHM Infected By Subprime Problems.

The tentacles of the subprime mortgage debacle have now reached even further. American Home Mortgage Investment, which specializes in both prime and “Alt-A” loans, which are riskier than prime loans but safer than subprime loans, is laying off 500 employees nationwide Thursday.

A senior staffer at AHM, who only agreed to speak anonymously, told Forbes.com that in their office, which only has 100 employees, 25 positions are being cut. “The company is calling this ‘the largest lay-off in AHM company history’ and a necessary reaction to market trends,” the employee said. "Unless volume increases in the next 60 to 90 days, most feel these lay-offs are only the beginning and additional lay-offs seem inevitable."

2007-07-26
American Home Mortgage cuts more jobs

American Home Mortgage Investment Corp., the beleaguered Melville-based mortgage bank, has laid off another 228 employees, bringing to 428 the number of job cuts this month, a company spokeswoman said yesterday.

Several current and former employees numbered the total planned layoffs at 1,200, including the 448 already announced. The company would not respond to questions about future layoffs.

Another cause for concern is the company's delay in scheduling the release of second-quarter earnings. The earnings are due by early August and historically American Home has set a date two weeks in advance. But no such announcement has been made.

One possible reason for this, analysts said, is that market turbulence makes it more difficult for the company to determine the value of the $10.7 billion in loans it was carrying as "Off-balance sheet securities" at the end of fiscal 2006. Many of these loans carry higher credit risk than those the company bundles and sells to investors, and if market conditions cause their value to drop, the company will be required to take an earnings mark-down.

2007-07-27
American Home Mortgage Investment Corp. Delays Payment of Dividends

The quarterly cash dividend of $0.70 per share on the Company’s common stock had been declared on June 15, 2007 and was to be paid on July 27, 2007 to all shareholders of record as of July 9, 2007. The Series A Preferred Stock dividend and Series B Preferred Stock dividend had been declared on June 15, 2007 and are payable on July 31, 2007, to shareholders of record as of July 9, 2007.

American Home Mortgage Investment Corp. is a mortgage real estate investment trust (REIT) focused on earning net interest income from self-originated loans and mortgage-backed securities, and, through its taxable subsidiaries, from originating and selling mortgage loans and servicing mortgage loans for institutional investors.

2007-07-28
American Home Mortgage yanks dividend at last minute

In a sign of continuing tumult at American Home Mortgage Investment Corp., the troubled Melville-based mortgage bank announced at 10:19 p.m. Friday that it would not deliver the 70 cent per share dividend that was to be paid out that day of major write-downs in its loan portfolios.

Company officials made the move, which they called a delay, because, "The disruption in the credit markets in the past few weeks ... has caused major write-downs of its loan and security portfolios and consequently has caused significant margin calls with respect to its credit facilities," according to a release.

Dividends were pulled "in order to preserve liquidity until it obtains a better understanding of the impact that current market conditions in the mortgage industry and the broader credit market will have on the Company's balance sheet and overall liquidity," the company said.

The deadline for American Home's second-quarter earnings release is August 8, but the company has yet to set a date for that announcement.

2007-07-29
American Home Mortgage says faces margin calls

American Home Mortgage Investment Corp. said its lenders are demanding it put up more cash after the mortgage lender wrote down the value of its loan and security portfolios significantly.

The company said in a statement released late Friday that as a result of the margin calls from lenders, it has delayed paying dividends on its common stock, and plans to delay payments on its preferred shares.

Margin calls can create severe difficulty for a company that depends on funds from its lenders to finance loans, and can force the company to sell assets or seek other financing. If the company cannot generate enough money to satisfy its lenders, in the worst case scenario it can be forced to reorganize its debt or file for bankruptcy.

One has to laugh at the staunch belief that that American Home Mortgage could maintain a 22% dividend while the share price and spreading credit risks said otherwise. That 22% dividend is now 0%. About that PE... Well there are no earnings.

James B. Stewart at the WSJ put out a buy recommendation apparently based on the following ideas.

• The carnage in the subprime-mortgage market should be reflected in its share price
• The good reputation of the company's management
• Its excellent liquidity
• Its lack of exposure to the subprime crisis

Excellent liquidity?! In the face of the debacle at Bear Stearns how can anyone think there is (or recently was) excellent liquidity in ANY mortgage related stocks?

Or are Mortgage "REITs" supposedly different? Did Stewart not see the debacle at New Century Financial Corporation? Was there any doubt that things were spreading from subprime to Alt-A to Prime?

If American Home Mortgage is facing margin calls what does that say about its use of leverage? The next question then must be: what does that say about the company's management?

I happened to talk to a commercial real estate developer going back some 30 years at the Agora symposium late Friday. He was not a reader of my blog and had no idea I had written about Sam Zell in a Vital Lesson From Blackstone. But somehow we got to discussing the Florida condo situation and other real estate woes when all of a sudden he exclaimed, "Commercial real estate is through". I asked him why and he told me about cycles: Residential followed by commercial followed by industrial, and how they peak in that order. He went on to tell me about how Sam Zell marked the top in commercial and there was at most one year left or so in industrial. The developer I was speaking to "cashed out" over the past few years.

Perhaps it's time to review Debating the Flat Earth Society (Part 1) and Debating the Flat Earth Society (Part 2). In particular, let's take a look at the addendum of part 2 written December 28, 2006. Here goes:

I want to include a few comments from Professor John Succo on Minyanville:

As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don’t understand this is that it is cumulative: the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?

Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn’t be if people managed risk properly but they do not. Easy money causes competition for “projects” to increase: companies with free money take risk with it for less and less return. We are seeing deals getting done in LBO land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that “money” out there rates of return drops dramatically. Everyone is starved for income.

At the very time that income and returns are dropping debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.

That was an on time, real time, warning from Professor Succo much along the lines of what I have been writing about in my deflation themes. The warning was virtually ignored by everyone. The arrogance in which it was ignored caused a total 100% wipeout of Bear Stearns' High-Grade Structured Credit Strategies Enhanced Leverage Fund. Sadly, some Bear Stearns investors wanted out as early as January but Bear Stearns would not let them out. I am sure those assets were worth something (perhaps even 60% or more) in January or even March, but Bear Stearns halted redemptions and held on until the fund went to zero. Lawsuits will fly over this.

If the market dips a bit more, the buy the dip mantra will be sung loud and clear. I have no doubt it will be based on an absurd Fed Model and/or expected interest rate cuts by the Fed (see Rate Hike Odds Plunge - Gold Should Benefit). Of course the same people were singing the tune: The Fed hiking shows the economy is strong.

The Fed Model was thoroughly trashed by Hussman (see Tightening Cycle) but that will not slow down the number of comments on it one bit. Earnings?! forget about it. Where are earning headed in a slowing economy? What are the forward earnings of Merrill Lynch (MER) , Lehman (LEH), Goldman Sachs (GS), and Morgan Stanley (MS) going to look like when it becomes harder and harder to get pools of CDOs out the door and demand for leveraged buyouts dries up? The earnings of American Home Mortgage (AHM) effectively went negative. There is only one reason to buy major market indices here (a belief that he greater FOOL theory will be revived) because the case sure can't be made on fundamentals.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Rate Hike Odds Plunge - Gold Should Benefit

Bloomberg is reporting BOJ Less Likely to Raise Rates as Stocks, Prices Fall.

The Bank of Japan is less likely to raise interest rates in August after global stocks slumped and the nation's consumer prices fell for a fifth month.

Investors see a 48 percent likelihood of a rate increase next month, down from 66 percent yesterday, according to Credit Suisse Group calculations based on the exchange of interest payments. Consumer prices excluding fresh food fell 0.1 percent in June from a year earlier, the government said in Tokyo today.

Japan's retail sales unexpectedly fell 0.4 percent in June, the Trade Ministry said today, as higher taxes, lower wages and a furor over lost pension records weighed on consumer sentiment.

Weak Data

"Given today's weak CPI and retail data as well as the stock decline in the U.S., there are more factors mounting against an August rate increase," said Hiromichi Shirakawa, chief economist at Credit Suisse Group in Tokyo. Shirakawa, a former central bank official, said he put the chances of an August rate increase at "less than 50 percent."

Consumer prices in Japan have failed to rise this year, after posting gains in eight months of last year. Those increases led to speculation that the economy was emerging from more than seven years of deflation that discouraged investment and consumer spending.

Nationwide core prices may fall as much as 0.2 percent in August and September because crude oil costs were near records in those months in 2006, said Takehiro Sato, chief Japan economist at Morgan Stanley in Tokyo.

Competition among mobile-phone operators is also exerting downward pressure on prices. KDDI Corp., Japan's second-biggest mobile-phone carrier, said last week that it will cut monthly fees by half, matching a move by larger rival NTT DoCoMo Inc.

Insane Worry Over Falling Prices

Japan is still worried about falling prices. Imagine that. The idea of course is absurd. Falling prices are actually the natural state of affairs as productivity is constantly improving due to advancements in technology. This allows more goods to be produced with decreasing effort (a price deflationary effect).

It is absurd to be worried about falling prices. Falling prices should be embraced. But worries over deflation in Japan caused Japan to go from surplus to having a national debt in excess of 150% of GDP (250% by some measures I have seen) as Japan fought deflation. What did Japan get for its deflation fighting policies? The answer is bridges to nowhere and massive amounts of debt.

What did the Fed get from fighting an imaginary deflation threat in 2001? The answer of course is the worlds biggest housing bubble, massive debt, tapped out consumers, and a real deflation threat. Of course deflation is not really a threat per se. Deflation is only perceived as a threat because of the insane bubble blowing policies and the risk of crash because of those policies. Deflation is needed to wipe out the many malinvestments of insane fiscal and monetary policy over the last 20 years.

In Inflation: What the heck is it? there is a quote from Ludwig von Mises who describes the endgame brought on by reckless expansion of credit: "There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved."

Thus the real threat is a policy of theft by inflation that steals from the poor and the middle class. Bernanke of course wants that policy of theft for the benefit of those having first access to money (banks and brokerage houses).

Rate Cut Odds Soar

Nonetheless the odds now favor rate cuts as the WSJ headline Futures Markets Bet Fed Will Cut Rates This Year shows.

Amid stocks battered by credit concerns and disappointing durable-goods and new-home data the futures markets now are betting that the Federal Reserve will cut interest rates this year.

Trading in December fed funds contracts translates into the market giving 100% certainty that the Fed will cut rates to 5% by the Dec. 11 Fed meeting from the current 5.25% rate.

That is up from about a 44% chance at Wednesday’s close. The market is pricing in roughly 50% odds that the FOMC could cut the rate as early as the September or October meetings.

Cleveland Fed Charts

The Fed charts do not go out to December but here is the September chart.



Notice how quickly the odds of FF rate holding at 5.25% have plunged with this market selloff. The odds of a 50 basis point cut have climbed to 20% by September. I doubt that but the odds that the next move is down regardless of what it may or may not do to the dollar are increasingly likely.

There has been a bit of a selloff in gold lately and part of that might be attributed to a yield curve that is inverting once again. Part of it can be contributed to a decrease in liquidity everywhere and raising of cash in conjunction with unwinding of leverage.

But this Fed like all others before it will respond the way they always do: by slashing rates and attempting to blow an even bigger bubble. But this is the end of the line. There is no bigger bubble than housing that will create enough jobs to allow a bigger bubble to be blown. The housing bubble was the "bubble of last resort". It cannot be revived by lowering interest rates.

But the Fed will try. The yield curve will steepen, and gold will take off on its next run higher. In the meantime, volatility in gold associated with the unwinding of leverage and various carry trades can be expected.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Vital Lesson From Blackstone

Before we get to the lesson, let' take a look at commercial REITs. (This will all tie together nicely I assure you). Please consider the following "TA Tips". Watch these three short videos (in order) for a good laugh: (Thanks to Ilya)

REITs discussion with Beejal Patel 2007-04-18
REITS continue to be high flyers...the sector is considered over-valued by many, but Beejal tells us why the technicals show why REITS will likely keep rising.

REITs discussion with Beejal Patel 2007-05-30
Buyouts in the REIT Sector bring back the bullish momentum...A look at the technicals behind the exchange traded fund that tracks the REITS.

REITs discussion with Beejal Patel 2007-04-17
Could the Commercial Reits Sector be ready for another leg up? Beejal takes a closer look at whether the long term bull market could continue.

It seems like it's strike three on commercial REITs. Now, for some charts.

Click on any chart for a sharper image.

2007-07-26 IYR Daily



IYR 2007-07-26 Weekly



Flashback November 20, 2006

Blackstone Acquiring Trust in Richest Buyout

The Blackstone Group, a private investment firm, said yesterday that it had agreed to acquire Equity Office Properties Trust, the nation’s largest office-building owner and manager, for about $36 billion.

The deal marks the largest leveraged buyout in history, eclipsing the $33 billion paid earlier this year for H.C.A., the hospital chain, and it illustrates how private equity firms continue to gobble up corporate America. Under the transaction, Equity Office will go from being a publicly held company to a private one. Blackstone will pay $20 billion and assume $16 billion in debt.

Equity Office, with some 590 buildings and over 105 million square feet of office space in major metropolitan markets, was created in 1976 by Sam Zell, a real estate tycoon who built the business through dozens of acquisitions that were worth, in aggregate, more than $17 billion. Last year, Equity Office acquired the Verizon Building on Sixth Avenue in Manhattan for $515 million.

Matthew L. Ostrower, an analyst at Morgan Stanley, called the proposed deal “a ground-breaking transaction for the real estate world in general and an earthquake for the REIT industry.”

Private equity firms are vying to hold the crown of having led the biggest buyout in history, and, with this deal, Blackstone will be able to do so at least for now. Blackstone will move ahead of Kohlberg Kravis Roberts & Company, which led the H.C.A. sale. Kohlberg Kravis also held the prior record with its 1989 takeover of RJR Nabisco, a deal that came to define an era when it was chronicled in the book “Barbarians at the Gate.”

The transaction comes amid a private equity frenzy for the next big leveraged buyout.

Matthew L. Ostrower, an analyst at Morgan Stanley, called the proposed deal “a ground-breaking transaction for the real estate world in general and an earthquake for the REIT industry.”

Oh it was "groundbreaking" alright. Groundbreaking in LBO stupidity, right up there in silliness with the AOL "take under" of Time Warner. Someone at Time Warner clearly lost their mind to approve that deal. And the Blackstone IPO itself sure was an "earthquake" given that it just might have been the deal that finally choked the IPO market.

On that note the Mish telepathic question lines are now open. Questions are now pouring in.

Q: What did Blackstone know that Sam Zell didn't?
A: Obviously nothing. One would have to be a fool to take the other side of a bet as Sam Zell especially when Zell was selling after a runup like that.

Q: Why did they do it?
A: Everyone was desperate to see who could pulloff the biggest deal, no matter how little sense it made.

Q: Why was funding available?
A: For the same reason funding was available for subprime lending until that blew up: fees. Underwriting big deals like this means huge fees to the brokerages. The lack of such deals going forward in addition to enormously reduced fees for packaging CDOs makes it very likely that broker dealers such as Merrill Lynch (MER), Goldman Sachs (GS), and Lehman (LEH) have peaked.

Q: Did Blackstone even think they knew something that Sam Zell didn't?
A: That is much harder to answer. If they did, they were wrong. Perhaps Blackstone only thought it could unload the junk to an even greater fool.

Q: Wasn't the greater fool theory at least part of the IPO of Blackstone itself?
A: Absolutely, so let's take a look at the chart.

Blackstone - BX



Flash Forward July 27, 2007

Blackstone Falls to Record Low in Debt Market Freeze

Blackstone Group LP shares fell to a record low, making the leveraged buyout firm the worst- performing initial public offering this year.

Blackstone has tumbled 23 percent since the New York-based company sold shares in June on mounting concern that the LBO market will dry up as investors shun riskier bonds and loans used to fund takeovers. Rival Fortress Investment Group LLC fell 1.8 percent to $18.96 today, 49 percent below the $37 high reached the first trading day in February.

"If you believe private equity is under some pressure, you are definitely going to take it out on these stocks," said Frederick Lane, managing director of Boston-based investment bank Lane Berry & Co.

Investors around the world are avoiding riskier assets such as the loans that finance LBOs after being stung by losses in the U.S. subprime mortgage market. That rout may hamper New York-based Kohlberg Kravis Roberts & Co.'s plan to raise about $1.25 billion in an IPO later this year.

Ryan O'Keefe, a London-based spokesman for KKR, declined to comment.

Shares of Blackstone, led by Stephen Schwarzman, fell $1.51 to $24.10 at 10:07 a.m. in New York Stock Exchange composite trading. It's the lowest price since it went public at $31 on June 21.

Chrysler, the Auburn Hills, Michigan-based automaker, and Alliance Boots Plc, the U.K. pharmacy chain that KKR is acquiring, failed to find buyers this week for $20 billion of loans. Ten banks, including Deutsche Bank AG and JPMorgan Chase & Co., were stuck holding the debt.

A Vital Lesson

Inquiring minds might be wondering if there is a lesson in all of this. Indeed there is. It can be found by comparing Sam Zell to Bear Stearns and also to the greed at Blackstone. Sam Zell sold when he could, not when he had to. Sam Zell got top dollar. Bear Stearns sold when it had to. The High-Grade Structured Credit Strategies Enhanced Leverage Fund went to zero when Bear Stearns HAD to sell it because of margin calls. See Implications of Basis Capital Fund Missing Margin Calls for more info.

Neither the Blackstone IPO or Sam Zell's sale to Blackstone that needed $16 billion in debt to finance could be accomplished in today's market. That is the lesson here: Sell when you can, not when you have to.

I must give credit where credit is due. That is a saying I frequently hear from Bennet Sedacca on Minyanville. He's one of the brightest minds I know. And as you can see by comparing Sam Zell to Bear Stearns, the difference is vital.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

USDA Prime Only

CNNMoney is reporting Wells Fargo Closes Nonprime Wholesale Lending Business.

Wells Fargo Home Mortgage, a division of Wells Fargo Bank, N.A., said today that it will close its nonprime wholesale lending business, which processes and funds nonprime loans for third-party mortgage brokers. In 2006, this business represented 1.6 percent of Wells Fargo's total residential mortgage loan volume of $397.6 billion(1).

"Wells Fargo will continue to offer nonprime loans in channels where the company has direct relationships with consumers, including Wells Fargo Home Mortgage's retail channel and Wells Fargo Financial, an affiliate of Wells Fargo Bank, N.A," said Cara Heiden, Wells Fargo Home Mortgage division president. "The decision to close our nonprime wholesale lending business has no effect on Wells Fargo's robust prime lending business which has long held an industry leading position. We will continue to offer prime loans through all our distribution channels, including wholesale."

"For the foreseeable future, we believe continued turmoil in the nonprime sector will result in financial returns for our nonprime wholesale channel that are not commensurate with the risks inherent in this business," Heiden stated. "As a result, we have chosen to discontinue this channel."

Press Release - Alternative Lending Wholesale Division to Close

A Message from Mike Lepore, EVP, Institutional Lending

Continued challenges in the nonprime market have made it impossible to generate acceptable returns that are commensurate with the risks in the Wholesale Alternative Lending business. Because we expect this trend to continue for the foreseeable future, we have made the very difficult decision to discontinue doing nonprime lending in Wholesale, and to focus only on prime lending in this channel.

Effective on Thursday, July 26 at 5 p.m. CT, we will no longer accept new applications through our Wholesale Alternative Lending channel.

Wells Fargo remains committed to making credit accessible to a wide spectrum of consumers, where consistent with our responsible lending practices. We will continue to follow our controlled, profitable growth strategy and sustain our industry leading position by offering nonprime loans through channels that enable direct access to consumers. Prospects for these businesses – which include Wells Fargo Home Mortgage Retail, and Wells Fargo Financial – continue to be promising.

Wells Fargo Email

Following is the email that went out to some mortgage brokers doing business with Wells Fargo.

To all,

It is with deep regret that the decision to close has been made. Thank you for all your support over the past 3 years. If you desire, you may contact me at ****.com [email address removed by Mish]. I hope that I may be able to work with all of you in another capacity sometime in the near future.

Best Regards,

Dave Driscoll
Account Executive
Wells Home
Fargo Mortgage

Some lenders are sure to follow suit and others will tighten lending standards dramatically. In the latter category is JPMorgan / Chase.

JPMorgan / Chase Tightens Lending Standards

JPMorgan / Chase announced Simplified Mortgage Disclosures, Product Choices for Non-Prime Consumers.

Chase today announced it:

• Has developed a new upfront disclosure in a simple format. Consumers now can compare important product features for traditional as well as non-traditional mortgages, including more information on how an adjustable-rate feature can affect the monthly payment
• Will require an initial fixed rate for at least five years on adjustable-rate mortgages for non-prime borrowers to reduce payment shock risk
• Will employ underwriting guidelines that require borrowers to demonstrate their ability to handle increases in interest rates on non-traditional mortgages
• Has tightened credit standards, including making adjustments to acknowledge declining home values in certain markets and reducing the use of high loan-to-value ratios and stated-income products
• Will continue to consider borrowers’ required property tax and homeowners’ insurance payments in determining affordability. Chase offers all its borrowers an option to escrow those payments with Chase
• Will continue its practice of not offering option ARMs, which can expose borrowers to negative amortization when their monthly payment does not cover interest costs

Yield Curve as of 2007-07-26



Chart thanks to Bloomberg.

A yield curve that is increasingly inverted typically is not good for gold, but the runup from $640 to $690 was overdue for a little pullback anyway. The key point is that after a very brief stint in flat to slightly positive territory, the yield curve has inverted once again. This time however it is the 3 year treasury with widest spread. That will not help home buyers one bit.

Fed to the Rescue?

Forget about it. Falling treasury yields will not help anyone that does not qualify with much tighter lending standards. Falling treasury yields will not remotely come close to helping those whose interest rates jumps 200-300 basis points or more. Heck, in spite of a recent treasury rally, 10-year rates are still higher than earlier this year. And, the Fed will not be acting in time to help anyone. It will be too little too late for most.

Anyone with a subprime loan whose rate will reset later this year, is in deep trouble. Pricing pressures on housing are going to get worse, much worse. Anyone who thinks the Fed can save housing is enormously mistaken.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Price Wars

Prices of goods and services have to go up. Right? At least that is what everyone keeps telling me. After all on the producer side of the equation, energy prices are soaring, raw materials prices are soaring, wages are rising in China, and a new minimum wage in the US will send wages up $.70 this summer and $2.10 by 2009 to $7.25 an hour.

Try again. Wal-Mart is Cutting Prices on 16,000 Items.

Wal-Mart Stores Inc., the world's largest retailer, set the stage for price wars Monday as it announced it's cutting prices on more than 16,000 items starting this week in a bid to turn around sales for the critical back-to-school season.

Shares of key retailers such as Sears Holding Corp. and J.C. Penney Co. (JCP) were down, as investors worried about how ensuing price wars would affect profit margins.

Wal-Mart's price cuts, which range from 10 percent to 50 percent, will be backed by a new ad campaign on how to save money as gas prices remain high and kids head back to school. The cuts are deeper and involve even more items than in the year-ago period and top the 11,000 items discounted in advance of last year's holiday season, according to Melissa O'Brien, a company spokeswoman.

Retail consultant Burt Flickinger III said that while he applauded Wal-Mart's move, he noted that the jury is still out on whether it will be effective.

"While it is a smart strategic move, it is going to add profit margin pressure, " Flickinger said.

Pricing Pressure

Pressure on corporate margins is only just beginning. What it costs to produce goods is basically irrelevant if supply is outstripping demand. There is currently overcapacity in damn near everything. We do not need more Wal-Marts, more Pizza Huts, more Applebees, more Targets, more auto capacity, more furniture stores, more Home Depots, or more nail salons. All of those and then some were way overbuilt as new housing subdivisions went up at a frantic pace. Commercial real estate followed residential and provided huge numbers of jobs (although at the low end of the scale).

The payback for this reckless expansion is now underway. Housing has blown up, and corporate expansion of retail is about ready to follow suit. Consumer discretionary spending will take a big hit as rising energy prices and mortgage rates eat away at paychecks.

Rising Minimum Wages Will Not Save The Day

Unfortunately, don't look for rising wages to save the day. That minimum wage bill is going to do nothing but cause problems. Businesses under pressure already will be reluctant to add workers. Instead look for increased layoffs from retail, financial, and service sectors.

Expect economists to be telling everyone "We can't have a recession with unemployment so low." Well we can and we will. That is what happens when overcapacity meets changing time preferences on behalf of consumers. Before this mess is over unemployment will be soaring. How much the government admits will be another story, but look for massive revisions with the next administration in 2008.

Corporate Profits Will Sink

Corporate profits are under pressure with financials leading the way. Kevin Depew was talking about this on Minyanville in point #2 of Five Things: Housing Slump Contained to Only Those Things Affected by Housing Slump.

Countrywide Financial (CFC), the biggest U.S. mortgage lender, reported its third straight decline in quarterly profit due to increases in late loan payments.

• Countrywide this morning reported that second-quarter net income fell 33% and revenue fell 15%.
• The company also reduced its forecast for earnings for this year.
• Why the grim forecast?
• The company said profit was hurt by impairment charges on securities backed by prime home-equity loans.
• Well, of course, they said that. This sub-prime mess is going to continue to hurt for awhile. Even Bernanke said so last week.
• No, sorry. Read that bullet point again: The company said profit was hurt by impairment charges on securities backed by prime home-equity loans.
• Countrywide Chairman and Chief Executive Angelo Mozilo said "delinquencies and defaults continued to rise across all mortgage product categories."
• The company also noted it has set aside $293 million for loan losses in the quarter, more than triple the level a year earlier, blaming a loan-loss provision of $181 million on prime home-equity loans, the Wall Street Journal said.
  

So profits are now being hurt by "Prime Loans". Fancy that. But this contagion is not going to stop with either housing or financials.

Check out this headline: FedEx Freight cuts fuel surcharge.

FedEx Corp.'s FedEx Freight and FedEx National LTL said Monday they will reduce their fuel surcharge by 25 percent, effective immediately.

Rates at FedEx Express and FedEx Ground are not impacted by change, FedEx said.

FedEx National is a long-haul, less-than-truckload service of the shipping corporation's freight unit.

Less-than-truckload, or LTL, carriers, usually fill their trucks with freight from a variety of sources and might re-sort and redistribute it at a company terminal along their route.

Overcapacity in shipping? You bet. What else can it mean when fuel surcharges are removed in smack in the face of crude prices near all time highs.

A few Charts
Click on any chart for a better view.

WMT



CFC



FDX



JBHT



HD



JCP




APPB



Containment

Containment is spreading to retail, consumer discretionary spending, and even shipping. The underpinnings that has kept speculation high and the stock market buoyant, are being removed one by one, sector by sector. The party is all but over but no one seems to have recognized it yet.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Pavlov's Dogs

The Washington Post is reporting Sales of new homes fell 6.6 percent in June

New single-family home sales fell to an annual rate of 834,000 from a revised rate of 893,000 in May, the Commerce Department said. Analysts polled by Reuters were expecting June sales to fall to an 895,000 unit pace from a previously reported rate of 915,000 units in May.

In June, the median sales price of a new home fell 1.3 percent to $237,900 from $241,000 in May. There were 537,000 new homes for sale in June, holding the same level reported in May. It would take 7.8 months to clear that inventory at the current sales pace, up from the 7.4 months reported in May.

"We need to see (housing) starts move lower," said Keith Hembre, chief economist at FAF Advisors in Minneapolis. "Not only were sales down, the homes available for sales were higher. I continue to believe that we are not anyway near the end of the adjustment in the housing market."

Key Points

• Prior months were adjusted lower (as usual)
• The magnitude of the plunge this month was huge.
• Inventory rises (as usual)
• Starts need to drop
  

Take a good hard look at point number three. Rising inventory means lower prices are coming. More subtly it means that many are trapped in homes that they cannot sell that they need to sell (because they can't meet their mortgage payments). This will increase defaults and eventually foreclosures and bankruptcies.

Now take a good hard look at point number four. Yes, starts do need to drop. A lot. That will add to unemployment. Look at the problems we are having with unemployment near all time lows. Think of the implications when unemployment rises to a mere 6%.

Treasuries are putting in a very nice rally just as the entire world hates them including foreign governments who after a huge 5 year rally are diversifying out of treasuries into equities.

click on chart for a sharper image



A liquidity crunch is on as I talked about in Avalanche of Leveraged Loan Supply and Liquidity Crunch Looms. But much like Pavlov's dogs, stock market bulls are salivating to buy the dip. Those bulls are ignoring the fact that risk is way underpriced and fundamentals as well as market psychology have dramatically changed for the worse. Yes a bell is ringing, but it is a liquidity warning not a dinner bell. The difference is vitally important even though both bells sound the same.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Avalanche of Leveraged Loan Supply

The Liquidity crunch took another step forward today as California Home-Loan Defaults Rise to a Decade High.

California mortgage defaults rose to the highest level in a decade in the second quarter as falling home sales and higher interest rates battered the housing market.

Homeowners received 53,943 default notices, more than double the 20,909 filed a year ago, DataQuick Information Systems, a La Jolla, California-based provider of real estate data, said today in a statement. Last quarter's default level was the highest since the fourth quarter of 1996, when 54,045 notices were recorded in California.

Californians are struggling to repay home loans as mortgage rates jumped to an 11-month high and tighter lending standards limited their ability to refinance. Southern California home sales last month slumped 36 percent to the lowest for a June in 14 years and San Francisco Bay Area sales fell 26 percent to a 12-year low, mirroring the national slump, DataQuick said last week.

Most of the loans that went into default in the second quarter were originated between July 2005 and August 2006.

Once again it is important to remember this is nearer to the beginning of the beginning rather than the beginning of the end. Housing can and will get much worse.

With that sentence, a telepathic question just snuck in: "OK Mish, that is housing, what about the leveraged buyout market?" The answers come from Bill Gross at Pimco who reports "Enough is enough" and from a Citi presentation that states there is an avalanche of leverage loan supply.

Stuffed

Bill Gross is saying Enough is Enough.

Both borrowers and lenders may have bitten off more than they can chew, and even those that swallow their hot dogs whole – Nathan’s Famous Coney Island style – are having a serious bout of indigestion. Several hundred billion dollars of bank loans and high yield debt wait in the wings to take out the private equity and leveraged buyout deals that have helped propel stocks to Dow 14,000. And lenders…mmmmm, how do we say this…don’t seem to have much of an appetite anymore. Six weeks ago the high yield debt market was humming the Campbell’s soup theme and now, it’s begging for a truckload of Rolaids.

As Tim Bond of Barclays Capital put it so well a few weeks ago, "it is the excess leverage of the lenders not the borrowers which is the source of systemic problems." Low policy rates in many countries and narrow credit spreads have encouraged levered structures bought in the hundreds of millions by lenders, in an effort to maximize returns with what they thought were relatively riskless loans. Those were the ABS CDOs, CLOs, and levered CDO structures that the rating services assigned investment grade ratings to, which then were sold with enticing LIBOR + 100, 200, 300 or more types of yields. The bloom came off the rose and the worm started to turn, however, when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space. Could the same thing happen to levered structures with pure corporate credit backing? To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.

Avalanche of Leveraged Loan Supply

Take a look at a few of these charts courtesy of Citi.

Avalanche of Supply




The Leverage Cycle



Typical CDO Haircuts



Blackstone IPO

The highly touted Blackstone IPO was arguably a watershed event just as the merger of AOL and Time Warner was back in the dotcom bubble. I was wondering if the market would start choking on or after the IPO. Well we have our answers. The IPO was a success but the patient is now looks sick.

Blackstone - BX



Bloomberg is reporting Blackstone Stock's Slide Makes It Second-Worst IPO.

Shares of Blackstone Group LP, which paid founder Stephen Schwarzman $684 million in its June IPO, have posted the second-worst performance for a U.S. initial public offering this year.

Shares of the New York-based private equity firm fell 15 percent in their first month of trading, according to Bloomberg calculations. Clearwire Corp., the wireless Internet service provider that went public in March, fell 20 percent in the first month. Last week, U.K. hedge fund manager Man Group Plc raised less than planned in the U.S. IPO of its MF Global brokerage unit. Its shares have fallen 10 percent.

Rising defaults in the subprime mortgage market have forced banks to tighten lending criteria and that in turn has affected borrowing costs for leveraged buyouts as well. Debt investors have backed away from buying risky issues, causing at least 35 companies to rework or abandon their LBO financing.

Rival buyout firm Kohlberg Kravis Roberts & Co., which also plans an IPO, was unable to sell $10 billion of senior loans to fund its buyout of pharmacy chain Alliance Boots Plc, two people with knowledge of the deal said today.

Chrysler, a unit of Stuttgart, Germany-based DaimlerChrysler AG, abandoned plans to sell $12 billion of high-yield, high-risk debt to finance its purchase by Cerberus Capital Management LP, investors briefed on the decision said today. Banks led by JPMorgan Chase & Co. will assume $10 billion of that debt and Cerberus and DaimlerChrysler agreed to hold the remaining $2 billion.

Tougher conditions in the credit market have spilled over to IPOs of other financial-services companies.

Widening credit spreads are not good for financials in general, and inability to funds CDOs and leveraged buyouts sure won't be good for the profits of broker dealers. Let's take a look at a few broker/dealer charts.

Goldman Sachs - GS Daily



The failure to hold the 200EMA maked the daily chart look quite sick. The weekly chart, however, does look better.

Goldman Sachs - GS Weekly



The implications are ominous if the 50EMA does not hold on a weekly basis.

Merrill Lynch - MER Daily



On a daily basis this chart is really busted with not only a close well under the 200 EMA but with the 50 EMA crossing under the 200 EMA as well.

Merrill Lynch - MER Weekly



Bear Stearns - BSC Weekly



Lehman - LEH Weekly



Lehman is yet another busted chart. Only GS has a weekly trendline intact. None have a daily trendline intact. Broker Dealers breaking down is not a sign of strength.

Everyone was waiting for a catalyst for a credit bust. If this is indeed it (and history has yet to speak), some may point to Blackstone, others to subprime contagion, others to Bear Stearns, but I don't think there really was one.

Earlier today I made the case that a Liquidity Crunch Looms. Kevin Depew also picked up on that theme in "Five Things" with a post about the Credit Crunch.

Whether or not this is "IT", the appetite for funding IPOs at insanely low spreads is simply not unlimited just as the appetite for housing was not unlimited (regardless of what anyone thought about demographics). If risk preferences are shifting (and it seems like they are) equities in general are simply not the place to be. Worse yet is an avalanche of supply right as the cycle has turned, when leverage has never in history been greater.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Liquidity Crunch Looms

Citigroup is reporting Defaults on Some `Alt A' Loans Surpass Subprime.

Defaults on some so-called Alt A mortgages packaged into bonds last year are now outpacing those from subprime loans, according to Citigroup Inc.

The three-month constant default rate for 2006 Alt A hybrid adjustable-rate mortgages is 2.3 percent, compared with 2.2 percent for subprime ARMs, New York-based Citigroup analysts led by Rahul Parulekar wrote in a July 20 report. The figures represent the percentage of balances in a mortgage-bond pool expected to default in the next year based on 90-day trends.

[Mish comment: Here's the key phrase "expected to default in the next year based on 90-day trends". Wasn't it reliance on trends that got rating companies into hot water in the first place? Essentially Moody's, Fitch, and the S&P, all used trends to predict that housing would rise forever into the future at a slow steady rate. None of the rating companies allowed for reversion to the mean or even a flat market for that matter. I talked about this in Fitch Discloses Its Fatally Flawed Rating Model. I suspect that we are going to find 2% is a very optimistic number. If nothing else the illiquid CDO market now acts as if 2% is optimistic.]

The speed at which Alt A hybrid ARMs are being paid off due to home sales or refinancing has also fallen to about the same level as for subprime ARMs, which typically prepay more slowly, the analysts said. Slower prepayments can make the same rates of defaults more damaging by leaving more of the initial balances outstanding to eat into bond-investor protections.

The combination of challenges mean 2006 bonds backed by Alt A mortgages, a credit grade above subprime loans, may need "lower loss severities to still come out with lower cumulative losses than subprimes," the Citigroup analysts wrote.

More than $800 billion of subprime mortgage bonds and $700 billion of Alt A bonds are outstanding, with ARM bonds totaling more than $600 billion and $450 billion, respectively, according to a March report by Zurich-based Credit Suisse Group.

[Mish comment: Those numbers are telling. $800 billion in total subprime debt, of which $565 billion is in the most toxic years (2005-2006) and a mere 3% of that debt has been downgraded even though Bloomberg calculates that a full 65% of that debt no longer meets the grades originally assigned. See Thoughts on Moody's "Tough Stance" for more information.]

The Citigroup analysts used Alt A ARMs with five years of fixed rates for their study. They didn't include so-called option ARMs, a type of loan with minimum payments that produce growing debt in $200 billion of Alt A bonds.

[Mish comment: There's nothing like excluding the worst of the garbage when coming up with your number.]

Between June 1 and July 17, typical spreads on BBB rated Alt A securities widened by 125 basis points to 475 basis points, while spreads for similar subprime securities rose 200 basis points to 450 basis points, according to Citigroup.

A Near Halt

As investors flee the market, a near halt in non-guaranteed mortgage-bond sales and a greater differentiation among securities with the same labels and ratings is limiting consensus among analysts on typical levels. Analysts at Credit Suisse and New York-based Bear Stearns reported higher spreads for both Alt A and subprime securities in reports last week.

[Mish comment: This is enormously compounding the ability of homebuilders to sell homes. Some are going bankrupt. It's the same every cycle. Risk is piled upon risk as trend players project the past forever into the future. Greed and fraud both run rampant then the whole thing blows up.]

Alt A and subprime loans compose about 13 percent to 14 percent of all outstanding home mortgages, according to estimates Federal Reserve Bank of St. Louis President William Poole cited in a speech last week.

[Mish comment: Bulls have been citing the small percentage of subprime debt as if it's too small to matter. How many times have we heard, subprime is only 8% of the market. Hmmm Now it's subprime and Alt-A are only 14% of the market. But is 14% the extent of the problem? Of course not. The right questions are: How much total garbage was rated "A" that did not deserve to be. How much of the originally deserving "A" paper also deserves to be downgraded? Thus a seemingly bullish factor is anything but. In fact it serves as a warning about how overrated all this debt was in the first place]

Mispriced Risk

Risk was seriously mispriced as evidenced by the complete collapse of the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund and the sudden widening BBB rated Alt A securities credit spreads by 125 basis points to 475 basis points.

Given how little debt has actually been downgraded so far, those spreads have a long, long way to widen.

CDOs Grind to a Halt

Bloomberg is reporting Homeowners Face Funding Drain as CDO Sales Slow.

The Wall Street money-machine known as collateralized debt obligations is grinding to a halt, imperiling $8.6 billion in annual underwriting fees and reducing credit for everyone from buyout king Henry Kravis to homeowners.

Sales of the securities -- used to pool bonds, loans and their derivatives into new debt -- dwindled to $9.1 billion in the U.S. this month from $42 billion in all of June, analysts at New York-based JPMorgan Chase & Co. said in a report yesterday.

From $42 billion to $9 billion is quite a collapse. Look at the reduction in underwriting fees. Think about how much harder this make it to buy a new house or sell and existing one. How quick we forget. Was it a mere 7 years ago that the same thing happened in the dotcom bubble?

The Ghost of Drexel Burnham Lambert

Kevin Depew on Minyanville gave everyone a history lesson in point one of Tuesday's Five Things.

1. Ghost in the Machine Slowly Grinding to a Halt

The market for collateralized debt obligations is slowly grinding to a halt, according to Bloomberg, threatening one of Wall Street's sacred cash cows - (read: $8.6 bln in annual underwriting fees) - and reducing the availability of credit for everyone from major Wall Street buyout firms to homeowners themselves.

• Sales of collateralized debt obligations (CDOs), which are used to pool bonds, loans and their derivatives into new debt, fell to $9.1 billion in July, down from $42 billion in June, analysts at JPMorgan Chase (JPM) said, according to Bloomberg.
• What's behind the declining appetite for CDOs?
• The near collapse of two Bear Stearns (BSC) hedge funds, for one. The downgrade of 75 CDOs by the ratings agency S&P, for two. And concern about growing losses due to rising homeowner mortgage defaults, for three. Those are just for starters.
• OK, so what are we really talking about here with these so-called CDOs?
• CDOs were created in 1987 by bankers at Drexel Burnham Lambert.
• Wait a minute.
• Did you say Drexel Burnham Lambert?
• Isn't that the same firm that was driven into bankruptcy in 1990 due to illegal trading in junk bonds driven by Drexel employee Michael Milken?
• And did you say they were created in 1987?
• The same year the market crashed?
• And wasn't the 1980s known as the "Decade of Greed"?
• Yes, yes, yes, yes and yes.
• So let's see if we got this right.
• Today, in 2007, the market for securities that were created in the "Decade of Greed" by a firm that was only a short time later forced into bankruptcy due to illegal trading in high-risk bonds is grinding to a halt?

They say that history does not repeat but it does rhyme. In this case they have it wrong. CDO History is indeed repeating. What will also repeat is how the Fed will react to the problem. That way of course will be the same way the Fed reacts to every problem (by cutting rates). Regardless of whether or not that tactic works the next time (I doubt it), the attempt itself should be good for gold as the yield curve steepens.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/