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Subprime's New Song:
The Worst Is Yet To Come
By Susan C. Walker,
Elliott Wave International
August 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 – 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
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
"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
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
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."
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. Her columns also appear regularly on FoxNews.com.
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.