Fed Delivers / Credit Woes Persist

A: Drug dealer Ben Bernanke & co. delivered a 1/4 pt rate cut to the addicted markets and all but declared, "NO MORE DRUGS FOR YOU"; let the hangover begin! Future actions are now entirely data dependent as the fed views current policy as balanced between inflation risks in the pipeline and slowing economic growth. The knee jerk rally on wall street was not surprisingly short-lived, especially as the deeper problems of credit woes began to resurface! This credit crunch is not over, and the news about foreclosures rising and expected delinquencies going into 2008 is not news at all if your on top of macro economy and reading your stuff!

First, I want to say one thing about the fed. The action taken yesterday is a preventative insurance policy for the economic weakness expected as the spillover of a nationwide housing slump and credit crunch hits the consumer in 2008! As I said in my post in mid August regarding 2008 ARM resets:

"It's 2008 that we have to worry about and how that may or may not further change the lending environment and ultimately housing."

Expect things to get worse before it gets better and the environment to be ripe pickings for contrarian investors whose eyes light up when an asset class gets to be really 'down & out'. I expect 2008 to be the year for these opportunities, possibly continuing into early 2009.

As far as the credit woes coming back to haunt the markets, it shouldn't be surprising to any readers of this site that foreclosures spiked higher & ARM rates rose! After all, the plunge in the ABX indices and the freefall in the mortgage insurers have been predicting this for weeks now. According to CNN Money:

Foreclosure filings climbed during the third quarter of 2007 with no relief in sight, according to a report released Thursday. The report by RealtyTrac, an online marketer of foreclosure properties, showed the number of filings rose 30 percent from the previous quarter and nearly doubled from a year earlier. More than 635,000 foreclosure filings were reported nationwide - one for every 196 households. The filings include everything from default notices to auction sale notices to actual bank repossessions.

"August and September were the two highest monthly foreclosure filing totals we've seen since we began issuing our report in January 2005," said Saccacio.

On to those that hold these dysfunctional loans turned into mortgage backed securities. There are billions and billions of dollars in bad assets held by banks, brokerages and lenders whose market value is virtually impossible to figure out. Even the holders of these notes don't know what they are worth. All we know is that the markets to buy these assets are in distress and selling at such unfavorable levels is extremely undesirable. So, you write down the losses without physically selling the assets; and this is what is happening. The problem with this is it doesn't cure the disease! Here is an idea of what we found out in the past week alone:

Citibank (NYSE: C) - It took more than $3 billion in writedowns in the third quarter on its exposure to leveraged loan commitments, subprime mortgages and fixed-income trading. Citi's total credit costs jumped by $3 billion, as the bank recognized $780 million in credit losses and took a net charge of $2.24 billion to increase loan-loss reserves.

"For Citi to re-establish an average tangible capital ratio of over 4.25%, Citi will need to raise over $30 billion of equity," she writes. "To do that Citi could cut its dividend, raise capital, sell assets, or a combination thereof. ... We believe such a catalyst will pressure the stock."

Merrill Lynch (NYSE: MER) - What is the balance sheet of Merrill Lynch really worth? Wednesday, Merrill reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations (CDOs), which are complex debt securities, and junk mortgages. What shocked the market was that only three weeks ago Merrill estimated losses of $4.5 billion on these sorts of assets. One cause was that Merrill gave the job of valuing these securities to a group of people who turned out to have a much more conservative view on these assets' true worth.

Credit Suisse (NYSE: CS) - Credit Suisse reported a 31% drop in third-quarter net profit Thursday after the credit market crisis wiped around 2.2 billion francs ($1.9 billion) off the value of its mortgage book and leveraged loan commitments.

We knew there was trouble in creditville and expectations of increasing foreclosures and delinquencies by monitoring what is going on in the ABX indices. I started reporting on this weeks ago, with posts and my statements below. While you read those over, glance at how the ABX 'AA' market is continuing to plunge, indicating investor expectations of more carnage to come before this credit mess can be declared over. Notice where the two red lines intersect indicating the point where the index blew past the low level reached when the credit crunch first hit us in August!

OCT 16th ---> "It was clear that equities were drunk on rate cuts, as I posted last week, and I think the street is yet to adapt fully to a world of credit restrictions, solvency issues, global inflation and higher rates. The first credit blip was an 'awakening' of sorts, and for those that think it's completely over, well, stop hitting the snooze button!"

OCT 18th ---> "Just a lot going on under the surface here folks that could lead to another round of credit woes when it reaches the top; that is mass media and consumers. In a sign that investor sentiment is plunging for mortgage backed securities, the ABX markets are getting whacked again. It's entirely possible that this leads to another round of seizing up of the secondary mortgage markets."

OCT 20th ---> "Now, I don't know how all this will end, but I do know that investors are pulling bids fast from the ABX markets and the mortgage insurance companies. These are NOT normal moves people and it's clear something is going on! Expect another round of uncertainty and media reports on the credit crunch, and the secondary mortgage markets to seize up again leaving no place for holders of these distressed assets to sell positions; which leads me to be very concerned about those entities that are forced to sell to meet debt requirements! I would also expect to hear more bad news from brokerages, hedge funds, banks, and other entities with uncertain exposure to these markets."

So, whats going on here? Other than uncertainty regarding the depth of the credit squeeze, I'm not sure! It's clear the fed is trying their best to eliminate the delusion from the tradable markets that their policy actions are taken to meet their demands. In other words, they don't want to be wall street's bitch anymore. But its also clear that the side effects of a nationwide housing slump are yet to hit full force. As for the credit squeeze, expect the secondary mortgage markets to continue to be in distress and for lending rates to behave independently of fed action and 10YR bond yields; as yield premiums rise for higher perceived mortgage risk. As long as there is no normal functioning market to unwind bad asset holdings, lenders will be very cautious to whom they hand out their capital via loans to and will demand high premiums for riskier borrowers, or not loan to these borrowers at all. They need to clean up their books and the end result of that is tighter lending / underwriting standards for new loans.

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