 Subprime's New Song:
The Worst Is Yet To Come
Susan C. Walker
Elliott
Wave International
Aug 28, 2007
Remember that catchy love song
that Frank Sinatra made popular in the 1960s, "The Best
Is Yet To Come"?
"The best is yet to
come and, babe, won't that be fine?
You think you've seen the sun, but you ain't seen it shine."
At the risk of mixing musical
metaphors and styles, it looks more like the sun has deserted
us right now in the financial markets, and we're about to see
"The Dark Side of the Moon," the title of Pink Floyd's
1973 smash album. With the subprime
mortgage problems reaching farther and farther out to touch
hedge funds, U.S. and European banks, mortgage companies and
money-market funds, what we're going to experience sounds more
like "The Worst is Yet To Come."
That's because the financial
markets must contend not only with the credit
crunch brought on by rising foreclosures now; they
must also deal with the repercussions from more foreclosures
over the next 18 months as more adjustable-rate mortgages (whether
subprime or not) reset from low teaser rates to higher interest-rate
levels.
How bad can it get? Investment
adviser John Mauldin recently published a month-by-month account
of the dollar amount of mortgages that will be reset through
2008, and the largest reset amounts pop up in the first
six months of next year. In fact, as he points out, the
$197 billion of mortgage resets so far this year is "less
than we will see in two months (February and March) of next year.
The first six months of next year will see more than the total
for 2007, or $521 billion."
So, we haven't even begun to
feel the pain yet. It's bad enough for the folks who will find
that they can't keep up with the higher mortgage payments and
will have to move out of their homes. But the financial markets
won't be catching a break either. The antiseptic phrase used
to describe the situation is "repricing risk." That
means that investors have woken up to the fact that the AAA-rated
mortgage-backed securities and derivatives they invested in look
more like junk bonds now. This eye-opener causes them to want
higher yields from what they now see as riskier vehicles.
That new investor caution plays
out this way: investment banks, hedge funds and any other entity
that bought securities backed by subprime loans now find it hard
to sell the darn things. It's almost the same as homeowners trying
to find buyers for their homes c nearly impossible in a market
where home
prices are falling. In the financial markets, it's nearly
impossible because no one even wants to attach a price to a collateralized
debt obligation today for fear that it will be priced much lower
tomorrow.
The Fed can try to calm such
fears all it wants by lowering the discount rate and giving banks
more time to pay back loans (from overnight to 30 days), but
the real problem can't be fixed with more access to credit. The
fact is nobody wants any more of that. What they really want
is cash to pay off their debts, be it a mortgage or an unwinding
of a securities bet.
Wall Street's denizens are
in the dark about how much their schemes depend on the ocean
of liquidity created by the bull market, say Elliott Wave International's
analysts, Steve Hochberg and Pete Kendall. They are particularly
struck by the image of the Grim Reaper that Business Week
magazine put on its cover recently with the headline, "Death
Bonds:"
"The grim reaper is the
perfect visage to welcome the arriving wave of liquidation; it
will wreak havoc with their work. The field's dark fate is clear
in one fund manager's description of what caused 'forced sales'
at another fund: 'The models work when they look at history,
but not when history is all new.' What's 'new' is that for the
first time in the experience of many model makers, confidence
is on the run. As they rob Peter to pay Paul, all assets will
be impacted in negative ways that do not compute in their models."
(The
Elliott Wave Financial Forecast, August 2007)
And the bad news just keeps
accumulating:
- Housing prices dropped 3.2%
percent in the second quarter compared with last year, the largest
drop since Standard & Poor's started tracking home prices
in 1987
.
- CIT Group closed its mortgage
unit this week, while Lehman Brothers closed its own last week.
Mortgage companies that specialize in low-quality mortgages are
either going out of business (London-based HSBC) or struggling
(California-based Countrywide)
.
- The Wall Street Journal
lists the number of fired employees at seven mortgage companies,
including First Magnus (6,000), Capitol One's Greenpoint (1,900),
Associated Home Lenders (1,600) and Lehman (1,200), which totals
more than 12,000 suddenly unemployed mortgage writers
To top it off, Bloomberg reports
that the subprime mess may lead to lower bonuses for the first
time in five years on Wall Street, according to Options Group,
a company that's been tracking this kind of information for a
decade.
Somewhere, the world's smallest
violin is playing a sad song for the fund managers and investment
bankers who won't be taking home that million-dollar-plus bonus
this year. And Frank Sinatra is singing a sad refrain... "The
worst is yet to come."
Aug 28, 2007
Susan C. Walker
Susan C. Walker writes for Elliott
Wave International, a market forecasting and technical analysis
company. She has
been an associate editor with Inc. magazine, a newspaper writer
and editor, an investor relations executive and a speechwriter
for the Federal Reserve Bank of Atlanta.
For more information on the
housing market and the credit crisis, access the free report,
The
Real State of Real Estate, from Elliott Wave International.
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