Wealth International, Limited (trustprofessionals.com) : Where There’s W.I.L., There’s A Way

W.I.L. Finance Digest for Week of February 4, 2008

This Week’s Entries : This week’s W.I.L. Offshore News Digest is here.


And a big opportunity looming in China.

Legendary investor Jim Rogers adds his voice to the chorus of those outright predicting bad things ahead for the late, great U.S. economy. A hefty portion of Rogers's fortune comes from predicting megatrends correctly and betting heavily on his predictions. When he says "I just see things getting much worse this time around than I expected," one had best pay attention. Likewise, when he welcomes the correction in China-related shares it is a good time to be taking a look there.

You might expect Jim Rogers to be gloating a little bit. After all, the famed investor has been predicting a recession in the U.S. economy for months and shorting the shares of now-tanking Wall Street investment banks for even longer. And with fears of a recession sparking both a worldwide market sell-off and emergency action from Federal Reserve chairman Ben Bernanke, Rogers again looks prescient -- just as he has over the past few years as the China-driven commodities boom he predicted almost a decade ago began kicked into high gear. But when I reached him by phone in Singapore the other day there was little hint of celebration in his voice. Instead, he took a serious tone.

"I am extremely worried," he says. "I have been for a while, but I just see things getting much worse this time around than I expected." To Rogers, a longtime Fed critic, Bernanke's decision to ride to the market's rescue with a 75-basis-point cut in the Fed's benchmark rate only a week before its scheduled meeting (at which time they cut it another 50 basis points) is the latest sign that the central bank is not willing to provide the fiscal discipline that he thinks the economy desperately needs.

"Conceivably we could have just had recession, hard times, sliding dollar, inflation, etc., but I am afraid it's going to be much worse," he says. "Bernanke is printing huge amounts of money. He is out of control and the Fed is out of control. We are probably going to have one of the worst recessions we have had since the Second World War. It is not a good scene."

Rogers looks at the Fed's willingness to add liquidity to an already inflationary environment and sees the history of the 1970s repeating itself. Does that mean stagflation? "It is a real danger and, in fact, a probability."

Where the opportunities are.

... [D]espite his gloomy outlook for the U.S., he still sees opportunities in today's world. In fact, he sees the recent correction as a potential gift for investors who know where to head in global markets: China. Rogers has been fascinated with China ever since he rode his motorcycle across the country two decades ago, and he has been a full-fledged China bull for several years. In December he published his latest book, an investor-friendly tome titled A Bull in China: How to Invest Profitably in the World's Greatest Market. And that same month he sold his beloved Manhattan townhouse for $15.75 million to a daughter of oil tycoon H. L. Hunt and moved his family full-time to Singapore -- the better to be closer to the action in Beijing and Shanghai. (He bought the New York mansion 30 years ago for just over $100,000; not a bad return on his investment.)

But in a November interview I conducted with Rogers, he admitted that he was rooting for a serious correction in China to cool off an overheating market and bring back prices to a reasonable level. With the bourses in Shanghai and Hong Kong both some 20% off their recent highs as of late January, Rogers says he is starting to consider new investments.

"I am delighted to see what is happening in Shanghai and Hong Kong," he says. "As I have said, if things had not cooled off, the Chinese market was in danger of turning into a bubble. I find this most encouraging. The government has been doing its best to try and cool things off. Mainly they have been trying to deal with real estate but it is having an effect on stocks, too. I would suspect the correction is not quite over in China. But I am gearing up. I did not put in any orders for tomorrow but I am starting to prepare my list of things to buy in China. Whether I buy this week or this month or this quarter, who knows. But I am starting to think about buying new shares in China for the first time in a while. And I am not thinking about buying in America."

Ultimately, Rogers does not think that the troubles in the U.S. will be much of a drag on the prospects for the People's Republic. "Anybody who sells to Sears or Wal-Mart is going to be affected, without question," he says. "Some parts of the Chinese economy are going to be untouched, however. They won't even know America's in recession. They will not care if America falls off the face of the earth." ...

What is on Rogers's China watch list?

What is on his China buying list? Rogers says it will depend in large part on which stocks come down to the right level, but he is keeping his eye on certain high-growth sectors including tourism, agriculture, power generation and airlines.

The pullback in commodity prices on recession fears has not dampened his enthusiasm for resources investments, either. More like a cyclical correction in the middle of a long-term bull market. "Certainly some commodities are going to be affected," says Rogers. "But it is not as if the markets haven't figured this out. Remember the old expression: 'Dr. Copper is the best economist in the world.' Well, Dr. Nickel and Dr. Zinc figured out a few months ago what I thought I had figured out, that we were going to have a recession. Nickel is already down 50%. Other commodities may fall more. But I do not see the economics of agriculture being much affected at all. Maybe there will be a few less cotton shirts bought. Maybe there will be a few less tires bought. But the supply is under more duress than the demand."

Once again Rogers draws on the 1970s in his analysis. "Think about the story of gold in the '70s," he says. "Gold went up 600%, and then it started correcting. It went down nearly every month for two years, nearly 50% from the high point. And everybody said, 'Well, that is the end of the gold market. It was just a fluke. It's over.' It scared everybody out. And then gold turned around and went up 850% from that level. This is what happens in markets. But the fundamentals of the secular bull market in commodities are not over any more now than they were for gold in the '70s."

Rogers has not covered his shorts in the investment banks or Citigroup.

Where he expects the pain to be most intense is on Wall Street. He says he has not covered his short positions on the investment banks or Citigroup and will not for a while. "Those things are going to go way, way, way down," says Rogers. "The investment banks are down now because of the problems in the credit market. Wait until the effects of the bear market come along. If you just go back and look at other bear markets, investment bank stocks have gone down enormously. We have not gotten to that stage yet. It is going to bring their balance sheets under duress. This is going to get much worse. But that is where there have been excesses for the past decade or so. And whenever you have a bear market come along the great excesses of the previous period are the ones that get cleaned out the most."

He will be watching -- from Singapore.

His point about how a bear market devastates the great excesses of the previous period has proven out time and again. A short list from U.S. stock market history would include the small concept stocks of the late 1960s, the "Nifty 50" large growth stocks of the early 1970s, energy stocks in 1980, small technology stocks in 1983, and dot-com + telecommunication stocks in the late 1990s. In each case losses of 80% or more were common after the group peaked.

There is a particularly debilitating double-whammy setup that comes into play during excesses: (1) The stocks get overhyped and overvalued, and thus are subject to normal market corrective forces. (2) The high valuations attract capital into the affected market sector, which fuels spending in the industry and temporarily boosts "fundamentals" while simultaneously creating excess capacity. When reality sets in, earnings and all the projected growth rates Wall Street heedlessly used to sell the IPOs on the way up both fall -- and disappear entirely for the lower quality companies in the sector. Multiples contract. Wall Street abandons its former favorite sons (which is great come buying time, when that time eventually comes around). Depending on how fast the capital stock becomes obsolete, the excess capacity can pressure margins and earnings for years.

To complete the list of areas of obvious excess from U.S. stock market history, add the financial stocks in 2005-06. The most flagrant excesses from the financial sector such as the subprime mortage lenders have already been wiped out. (Note that the allegations of fraud coming out here now, after the fact, are typical hangover symptoms of excess being corrected. No one cares on the way up, when everyone is still making money.) Citigroup and the investment banks are nominally more respectable than the subprime brokers, and certainly have more political support -- too big to fail and all that. But they have a lot of unaccounted-for bad assets and, characteristic of financial companies, a lot of leverage. A lethal combination. Thus Rogers's bet that there is more downside there.


Peter Schiff, author of Crash-Proof: How to Profit From the Coming Economic Collapse, and who is to Jim Cramer as matter is to antimatter, shares his typically blunt opinion of the latest series of interest rate cuts by the Fed.

Despite the fact that the Fed still believes that a recession is unlikely to occur, Bernanke & Co. followed up on [their] emergency 75 basis point rate cut with [another] 50 basis point kicker ... Not to be outdone by the Fed’s generosity, the House of Representatives and the Bush Administration slapped together a $150 billion "stimulus package", which can only be delayed by the Senate's desire to join in the bead throwing. On Wall Street these actions were cheered as heroic, with praise and accolades for all (what could be more politically courageous than handing out free money in an election year.) In a recent poll, fully 78% of economists thought these policies were appropriate ... while 18% thought that they were not aggressive enough.

So 96% of economists polled thought the policies were "very" or "extremely" appropriate, to posit how the poll results would read if it had been conducted using standard consumer survey lingo. This tells you all you need to know about current macroeconomic theory: It is a great wasteland, as it has always been.

A common definition of insanity is the act of repeating the same activity while expecting a different result. Bernanke is now repeating the same mistakes made by Greenspan, yet he and almost everyone on Wall Street expect a different result. The stock market bubble of the 1990s resulted from interest rates being too low, which sent false signals to businesses, causing them to over-invest in information technology, telecom, and dot coms. When that bubble burst, rather than allowing the corrective recession to run its course, the Fed responded by slashing interest rates. The result was an even larger bubble in real estate; causing consumers to borrow far too much money to buy houses and other goodies.

Now that the housing bubble has burst, the Fed is once again slashing interest rates to postpone the pain. However, in order to correct for years of extravagant borrowing and spending, the country is in desperate need of a period of saving and economizing. But by rewarding debtors and punishing savers, lower interest rates actually encourage the opposite behavior. Given how much harm this strategy has already done in the past why should we assume it will work any better now?

Consider a real world example. Suppose your spendthrift neighbor, maxed out on credit card and home equity debt, no savings in the bank, struggling to make ends meet and one paycheck away from foreclosure and personal bankruptcy, comes to you for financial advice regarding what to do with the $1,200 he received in the Federal Stimulus Lottery? Would your advice be to “go out and buy yourself a brand new plasma T.V.”? My guess is that you would suggest he pay down his debts. If you were a good friend you might help him devise a budget to put his financial house back in order. Such a plan might include trading in his Mercedes SUV for a more fuel-efficient Honda, brown bag lunches instead of expensive restaurants, tearing up department store charge cards, canceling vacations, cutting back premium cable channels, etc. When you are neck deep in debt, the solution is to economize, ratchet down your lifestyle and repair your personal balance sheet. In other words, you go though your own personal recession.

Would your advice be any different if it was not just one neighbor asking but 300 million? If it is wrong for an overly-indebted individual to blow a windfall, it is just as wrong if millions of us do it collectively. If our economy is already suffering from too much debt, think of how much worse off we will be after we blow through these rebate checks.

Or think about it this way -- Imagine an obese individual showing up at a Weight Watchers meeting and his counselor handing him a box of Twinkies? How much weight do you think would be lost on the "Twinkie diet?" American consumers have basically stuffed themselves almost to the point of explosion. What is needed is salad; not more Twinkies.

Ironically of course, by blowing up both the stock market bubble in the 1990s and the real estate bubble that followed, Greenspan actually repeated the same mistakes that previous Fed chairmen Benjamin Strong and William McChensey Martin made in the 1920s and the 1960s respectively. It seems sanity is a major disqualification for central bankers.


Bill Gross, uber-bond fund manager and one of the most respected credit market analysts around, puts his finger on one of the great charades making the rounds. Everyone knows the "monoline" bond insurers are bankrupt in the sense that their assets come nowhere close to covering their liabilities. But somehow, it is argued, the system's financial survival depends of deferring the recognition of this fact.

What is good for Ambac, the bond insurer, is good for the country. Well, perhaps in the short run if it prevents a run on the shadow banking system -- our over-leveraged system of financial conduits that have provided the spending power to keep the U.S. economy going in recent years. But not in the long run.

"Shadow banking system" is a great description of the whole structure.

The Ambac business model is as faulty now as was chairman Charles Wilson's forecast for General Motors more than a half century ago. Wilson's response to a U.S. Senate inquiry in 1955 implied that GM's near monopolistic control was beneficial to the country. It was, until the domestic motor industry fell asleep at the wheel of innovation and became more concerned with placating its labor unions with outsized pay packages and long-term pension and healthcare benefits. Creative destruction and the incessant march of globalization changed a GM chairman's smile to a frown, and the U.S. economy turned from industrialization to financialization in order to stay at the top of the global pecking order.

Those who put their faith in the ability of a finance-based economy to remain healthy are being similarly challenged today. A critic can find numerous examples of incredible, bubble-popping asset structures -- from subprime mortgages to structured investment vehicles to collateralized debt obligations squared -- that are threatening to reverse the expansion of the shadow banks and break our finance-based economy's back. The most recent one, however, centers around the monoline insurers with Ambac as the most important link in the chain that presumably cannot be allowed to break.

Monoline insurers are so named because they originally covered just one line of business -- municipal bonds. Today, however, because they do not insure lives, or automobiles or medical expenses, the name has stuck despite their additional reach into insuring financial assets of all varieties. In a real sense, the monolines have taken on their shoulders a supersized portion of the guaranteed solvency of modern asset structures. In combination with overly generous triple-A ratings on not only these assets but the monoline companies themselves, they have fostered a bubble of immeasurable but clearly significant proportions.

That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5 billion, insure the debt of the state of California, the world's 6th-largest economy? How could an investor in California's municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation's largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years -- subprimes and CDOs in the trillions of dollars -- and you must come to the same logical conclusion: this is absurd. It is as if Barney Fife, television's [comically inept] Sheriff of Mayberry in The Andy Griffith Show, promised to bring law and order to the entire country. [Or as if the President of the U.S. promised to end tyranny as we know it ... Oh, yeah, he did do that.]

As long as the illusion lasted, however, it is clear that monoline guarantees fostered an expansion of our modern shadow banking system and therefore an extension of U.S. and even global economic prosperity. Because U.S. consumers were able to borrow at "guaranteed" triple-A rates with an additional servicing/underwriting spread, their spending power was artificially elevated. In order to maintain those levels and avoid a nasty recession, authorities through both official and backdoor channels now endorse a rescue effort. What is good for Ambac, they reason, is good for the country -- and by extension the world.

As stock markets rise on optimistic workout developments, it is clear that it is -- in the short run. But like General Motors a half century back, the sense of stability imparted to an oligopolistic industry with visible flaws is not likely to last, nor may the hope for a return to economic growth of recent years. The modern U.S. financed-based economy has a striking resemblance to Barney Fife, guaranteeing global prosperity without the productive industrial-based firepower to back it up. Neither ultra-low interest rates or tax rebates, nor investor-led and authority-based monoline bailouts are likely to change that significantly during the next few years.

Gross fails to indentify the biggest AAA fraud of them all: the U.S. government. The government goes around bailing out and guaranteeing every system-threatening loss that crosses its desk, despite having liabilities hugely in excess of its assets. It is essentially a giant bond insurer plus a printing press. If the bond insurers could print stock certificates and force you to accept them as settlement for your losses insured by them, you would pretty much have the U.S. government.


Doug Nolan, writing in PrudentBear.com's Credit Bubble Bulletin, starts from the demise of the monoline bond insurers to reveal how "Wall Street Finance" is a "daisy-chain of interrelated weak underlying structures, unrecognized risks and acute fragilities."

The financial crisis took another giant leap this week. Credit insurer ("financial guarantor") Ambac lost its AAA rating (from Fitch), in what will mark the onset of a devastating run of downgrades for the likes of Ambac, MBIA and the entire industry. The "monoline" insurance business, as we have known it, is done and the value of the insurance they have written is evaporating by the day. The market is now desperate to determine which financial institutions (and there are many) have purchased large amounts of (now suspect) insurance for hedging purposes, as well as other financial companies that have in one way or another participated in the Credit "reinsurance" market.

Virtually all the major financial players are embroiled in this systemic credit fiasco. Importantly, the mind-blowing demise of the "financial guarantors" is fomenting a crisis of confidence in credit insurance in all its various forms (certainly including the Credit Default Swap (CDS) and MBS guarantee markets). According to Bloomberg news, $2.4 trillion of securities are at risk to the financial guarantor industry downgrades. I am assuming that our policymakers will attempt to throw together some type of industry recapitalization strategy, although the complexity of the issue leaves one perplexed as to how any bailout plan would be structured. I suspect that our federal government will eventually be forced to enter the "financial guarantee" business, at least to the point of assuming the obligations of municipal bond (from the "monolines") and mortgage-backed securities (from the Government Sponsored Enterprises) insurance.

The credit system is today an incredible mess. Literally [$]trillions of securities, previously valued in the marketplace based upon confidence in the underlying financial guarantees, are now suspect. This has severely impacted marketplace liquidity. And perhaps tens of [$]trillions of credit and other derivative contracts are now subject to very serious counterparty issues. Many players throughout the credit market are now severely impaired and have lost the capacity to hedge against/mitigate further losses.

To be sure, discontinuous and illiquid markets have wreaked bloody havoc on "dynamic" trading strategies used commonly to hedge various risks. I do not believe it is hyperbole to suggest that "dynamic hedging" (in particular shorting credit instruments to provide the necessary cashflows to pay on credit derivative contracts written) became the critical linchpin of contemporary Wall Street risk intermediation. Yet today the models behind so many strategies that have come to permeate "contemporary finance" have completely broken down; the strategies of thousands of financial institutions -- big and small -- have turned infeasible.

From a macro perspective, Wall Street risk intermediation has essentially crashed and the "risk markets" essentially "seized up." Almost across the board, the major risk operators are moving aggressively to rein in risk-taking. The leveraged speculating community is in turmoil. The "quants" are in a quandary. Basically, the entire market today desires, at least to some extent, to reduce/mitigate/transfer credit and market risk. Inevitably, however, when "the market" is keen to hedge there will be no one with the necessary wherewithal to take the other side of the trade. I have so many fears I do not even know where to begin, although I will say that I am less than comfortable these days discussing individual companies. Tonight the (brief) analysis will be in generalities.

There are scores of financial players -- from small hedge funds to the major "money center banks" -- with complex books of derivative trades that now have a very serious problem. These "hedged books" contain various supposedly offsetting risk exposures that, in their entirety, were [supposed] to have created (through financial "alchemy") a reasonable and manageable portfolio risk profile. But the breakdown in Wall Street finance has transformed these too often highly leveraged "books" into essentially unmanageable "toxic waste" and financial land mines.

First, correlations between various instruments have broken down (e.g., junk bond spreads widen while "dollar swap spreads" narrow). Second, the liquidity profile (hence pricing) of various sectors has diverged radically (e.g., agency MBS vs. "private-label" MBS/ABS) -- with the Treasury market melt-up causing further destabilization. Third, with the breakdown in Wall Street's "private-label" MBS market and the collapse in confidence in the "monoline" credit insurers, liquidity has all but evaporated throughout huge cross-sections of the debt securities and related derivatives markets. This dynamic is fomenting dangerous counter-party risks and uncertainties. The capacity of a rapidly rising number of market participants to fulfill their obligations in various types of derivative and "insurance" contracts is in question. Imagine you have a "hedged book" of securities and derivative -- for example a portfolio of CDOs hedged with Credit Default Swaps from one of the "monoline financial guarantors." Today, the value of your CDO portfolio is declining while the "value" of your offsetting CDS hedge is impaired by the increasing likelihood of a default by the "monoline" (who provided the CDO default "insurance"). The reality is that the hedged position has broken down and risk now rises by the day. And, unfortunately, your options are decidedly limited -- there is little if any liquidity to sell the underlying CDO. One could go into the market and attempt to buy additional protection, although in many cases the cost would be prohibitive. Besides, there is today little assurance that counter-party risks would not emerge in the second hedge as well.

Those who have been long-time critics of excessive speculation in derivatives have been warning of exactly such a scenario for years. In the 2002 Berkshire Hathaway annual report, Warren Buffett warned that derivatives were "time bombs", "mega-catastrophes" and "weapons of financial mass destruction" that could harm their buyers and sellers, as well as the whole economic system. He said the contracts appeared to have been designed by "madmen". This was not just pontification from a distance. After Berkshire purchased General Re, Buffett liquidated that company's derivatives positions, and ended up realizing $400 million or so less than what the accountants had asserted was fair value. And this was when the derivatives market was good. Did any of Wall Street's major players listen? As far as we can tell, only those who already thought -- and worried -- similarly. (For a particularly myopic unclear-on-the-concept reaction, see "Warren Buffet on Derivatives: Good For Me, But Not For Thee".)

The Wall Street firms and many of the more sophisticated hedge funds run very complex "books" of securities and derivatives. The dilemma they face today is commensurate with the complexity of their strategies. Recent developments -- in particular heightened marketplace illiquidity, rising probabilities of "monoline" defaults, dislocation in the CDS markets, and a breakdown in typical correlations between instruments/sectors/markets -- makes the job of effectively comprehending, quantifying, analyzing and managing risk impossible. Do the managers, then, attempt the highly problematic task of recalibrating hedges based on current conditions (i.e., spiking hedging costs, likely counterparty defaults, and recent market correlations) and risk compounding the problem if market conditions begin to normalize? Is it feasible for these players to recalibrate hedges, knowing full well that our well-intentioned policymakers are destined to intervene clumsily in the marketplace?

Now government intervention designed to stabilize the markets has become an additional risk factor.

It is difficult for me to believe the leveraged speculating community is not in serious jeopardy. It became all too commonplace to leverage illiquid (and difficult to price) securities, while even the previously liquid markets today barely trade. Few speculative bubbles in history were as vulnerable to a "run". None were remotely as gigantic or global in scope. This "community" today creates a systemic weak link on several fronts, certainly including the vulnerability to outsized losses and resulting redemptions instigating panic dynamics. Today, market illiquidity increases the likelihood that many funds will be forced to halt redemptions. This dynamic has commenced and it holds the potential to batter industry trust and confidence.

The leveraged speculators create various systemic risks. Their desire to hedge risk exposures -- as well as seek speculative profits -- during market turbulence has certainly exacerbated the credit crisis. During the cycle's upside, their affinity for leveraging securities greatly amplified the liquidity bull run. Today, their selling/deleveraging/hedging foments liquidity crisis, fear and market dislocation. Importantly, the speculators are today keen to short stocks, sell futures, and purchase equity put options. The "hedge funds" have, after all, sold themselves as capable of minting money in any kind of market environment. This could prove a major systemic risk.

Leveraged speculator dynamics in concert with a bursting credit bubble now places enormous strains on the stock market. Not only have faltering credit availability and credit marketplace biquidity dramatically diminished the prospects for companies, industries and the general economy. Limited liquidity in the credit market has also created a backdrop where those seeking to hedge (or profit from) heightened systemic risks have few places to go for relatively liquid trading outside selling stocks and equity index products. And sinking stock prices further aggravates the unfolding corporate credit crisis, fostering only greater systemic stress and greater selling pressure. "Contemporary finance" is being exposed as a daisy-chain of interrelated weak underlying structures, unrecognized risks and acute fragilities.


The troubled lender posted a $422 million loss and revealed that a third of its subprime loans are delinquent.

Apropos Jim Rogers's and our comments above regarding excesses in the financial sector: Countrywide Financial rode the mortgage boom high and far while maintaining a sheen of respectability. It would be fair to characterize it as "the cream of the crap" in the subprime mortgage origination business. As mentioned above, most of its smaller counterparts are already gone. Now Countrywide itself is clearly at risk, although as a credit bellweather the banks have apparently decided it should be bailed out. Countrywide's branch network is worth something, but the deteriorating value of its retained -- often involuntarily -- mortgage portfolio bodes ill.

Countrywide ... reported a loss of $422 million in the fourth quarter and revealed that an astounding 1/3 of its investment portfolio's subprime mortgage loans are delinquent. The loss threw cold water on Countrywide chief operating officer Steve Sambol's confident assurances to investors in October that, "We view the third quarter of 2007 as an earnings trough, and anticipate that the company will be profitable in the fourth quarter and in 2008." Seen in this light, Countrywide's fourth-quarter loss, compared to a $621 million profit a year ago, is what the numerous class action attorneys circling Countrywide will surely call "an unfavorable fact." Countywide finished 2007 with a loss of $704 million.

The numbers did not appear to faze Bank of America CEO Ken Lewis's determination to acquire Countrywide, however. ... Just over two weeks ago, BoA agreed to buy ... Countrywide in a $4 billion deal. If and when the deal goes through, the combined company will control just over 25% of the U.S. real estate loan origination market. The market took the highly scripted BoA support as crucial and sent Countrywide stock up 20 cents to $6.15.

At the fulcrum of the mortgage credit crisis, Countrywide's earnings are seen as a bellwether for the once vibrant -- and now largely collapsed -- U.S. mortgage industry. The primary culprit remains a combination of old-fashioned credit deterioration plus an alarming new development: Borrowers simply are walking away from their homes as their equity value falls ever further below their loan amount.

With respect to credit problems, Countrywide is unmistakably going from bad to worse. The home lending giant reserved $924 million for credit-related losses in the fourth quarter -- over a dozen times more than what it set aside in the fourth quarter of last year. To be fair, the $924 million figure is a bit of an improvement from the third quarter's $937 million reserve.

Countrywide's eye-popping 33% delinquency rate on its sub-prime mortgage book ... [highlights] a central fact ... : Countrywide's portfolio of sub-prime loans consist of those that were not previously written down, or could not be sold or securitized. In other words, this portfolio is likely to get much, much worse.

Perhaps as worrisome was the credit deterioration on the conventional loan portfolios, where delinquency rates spiked to 5.76% percent from 4.41%. Along similar lines, Countrywide also said it shifted $7 billion of "prime non-agency" loans to the portfolio -- out of the held-for-sale inventory - because it appears that there were no buyers likely to be found for this paper. ...

As home values drop to levels far below the mortgage amount, it simply becomes more economically advantageous for certain borrowers to hand over their keys. In a foreclosure, a mortgage lender often winds up booking losses that approach or even outstrip its loan amount when it sells the property into a distressed market.

The delinquency rates on conventional mortgage loans is what really bears watching from here. The size of this market dwarfs the subprime mortgage market, and it could sink a lot more than just Countrywide if it gets much worse.


A Credit Bubble Bulletin from a couple of weeks ago describes one of the migrating effects of the credit cruch: The mortgage crisis has evolved into "an incurable corporate debt crisis."

The financial system fell under intense stress Wednesday [January 9]. The epicenter of the crisis was in the "Credit Default Swap", or CDS market, and "contagion" fears were building quite a head of steam. The pricing for Countrywide Financial default protection (5-year CDS) surged a huge 469 basis points to a record 1,610 basis points (it would cost $16,100 annually for 5-yrs to insure $100,000 of Countrywide debt against default). For perspective, Countrywide default protection was priced at a mere 30 basis points one year ago and did not even trade above 600 during the subprime crisis this past summer and autumn. Rescap CDS surged an astounding 1,360 bps Wednesday to 3,746. This was up from the year earlier 95 bps. MBIA CDS increased 85bps to 849 (year ago 87) and Ambac 89 bps to 841 (year ago 70bps). Washington Mutual CDS increased 61 bps to 611 (year ago 54 bps). Many indices of corporate debt spreads rose to their widest levels in years.

In the old Greenspan days, Wednesday's circumstance would have most-likely beckoned a "surprise" inter-meeting Fed rate cut. There were rumors for as much. And while chairman Bernanke did not ease rates, Thursday morning he provided the markets the next best thing: "We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."

Bernanke did not plan on rambling down the Greenspan path. Actually, I believe he and other members of the FOMC would have preferred to avoid it -- resist responding directly to Wall Street pleas for aggressive Federal Reserve accommodation. "Let the chips fall ...", as they say. But the Fed now knows what many on Wall Street have understood since this summer: The U.S. credit system and economy are extraordinarily fragile and the Fed simply will not risk sitting back and watching an implosion without resorting to extreme measures. If nothing else, inter-meeting "surprise" rates cuts are back on the table. Wall Street must be quite relieved to know this mechanism is available in the event market selling pressure turns unwieldy.

This week brought back memories of the 2002 debt crisis. Weighed down by the telecom debt collapse, Enron, and other frauds, intensifying corporate debt problems late in the year were at risk of smothering the consumer sector. The nexus at the time was the auto finance subsidiaries and Household International. Consumer finance corporate debt spreads were widening significantly, and Household, in particular, was facing a liquidity crisis in early November. The failure of a major financial institution at that juncture would have created a major systemic issue.

Well, on November 14 HSBC agreed to buy (bail out) Household International. A week later, FOMC governor Bernanke gave his now (in)famous "Deflation: Making sure 'it' doesn't happen here" speech. With rates at 1.0% (until June 2004!), the Fed was now publicly discussing "electronic printing presses", "helicopters" and other "unconventional measures." Wall Street was trumpeting "deflation" risk. Sure enough, the crisis was soon resolved and Wall Street was emboldened to perpetuate history's greatest credit inflation and mortgage fiasco.

The tables have been turned these days, with the mortgage crisis now evolving into a full-fledged corporate debt crisis. The key nexus this time around has been Wall Street "structured finance", especially as it relates to the major Mortgage lenders --certainly including Countrywide, Rescap/GMAC, and Washington Mutual -- and the "financial guarantors -- in particular, MBIA and Ambac. The unfolding mortgage implosion has destroyed the value of innumerable "structured products"; has annihilated legions of mortgage companies; has impaired scores of major lenders; has severely battered general market confidence; and this week was in the process of taking down a few huge mortgage companies. Institutions with enormous liabilities to the "money", "repo", securitization, and derivative markets -- not to mention large borrowings from the FHLB system -- were in serious jeopardy. The risk of a domino implosion in the credit default market and the "financial guarantor" industry had become a very real possibility. System Risk Intermediation was in peril.

The Fed responded with what the market has interpreted as a promise of aggressive rate cuts, while Bank of America has apparently for now resolved the Countrywide debt issue. Citigroup's stock rallied on rumors of a major new investment from Prince Alwaleed and others. Washington Mutual's stock price rallied sharply on rumors of merger talks with JPMorgan. Countrywide's stock surged as CDS prices collapsed, a dynamic sure to have caused considerable grief to those shorting the stock to hedge against default protection written.

Curiously, the general market took little comfort from developments. A case can be made that the rally in CDS and financial stocks was destabilizing for much of the leveraged speculating community (including "market neutral" and "quants") keen to short financial stocks against (now sinking) technology shares. Overall, the market was hammered, while MBIA and Ambac CDS prices barely budged from record levels. ... And it is worth noting that an index of Junk bond spreads to Treasuries actually widened an additional 4 basis points to 603 bps, rising this week above 600 for the first time since -- not coincidently -- the 2002 Debt Crisis.

But the general environment is nothing like 2002, and I do not expect Fed words and actions -- in concert with financial bailouts -- to have similar effects. For one, 13% household mortgage debt growth in 2002 provided powerful financial and economic stimulus that will not be forthcoming in 2008. With consumer credit relatively stable, 2002's corporate debt crisis was not a serious systemic issue. Moreover, "Wall Street finance" was in an aggressive expansionary mode and the global banking community was developing quite a hankering to participate in the U.S. credit bubble. The economy was emerging from a shallow recession.

The world is a much different place today. The mortgage finance bubble is a bust, Wall Street finance is imploding, and foreign financial institutions are keen to cut and run from the business of providing U.S. credit. Countrywide's mortgage problems will be absorbed -- along with so many other risks -- by our own highly vulnerable domestic banking system. Worse yet, the economy is quickly succumbing to recessionary forces. With a high degree of confidence we can proclaim that the mortgage crisis has now evolved into a corporate debt crisis -- and this crisis will not be resolved anytime soon -- by rates, by helicopters, or by bailouts.

Unlike 2002, today's credit crisis is systemic. Consumer and financial sector fragilities -- the heart of our credit system -- are now impaired to the point of imperiling the capacity of the credit system to finance business spending and intermediate corporate lending risk. To be sure, prospects for a faltering U.S. consumer sector, massive financial sector cedit losses, and an imminent economic downturn have quite negative ramifications for business lending and valuations. In particular, unfolding dislocation in the CDS and credit "insurance" markets will severely restrict credit Availability for small, medium and large firms -- especially those less than top-tier borrowers.

I will go further and suggest that a severe tightening of financial conditions has abruptly made many business borrowing plans unviable; many a balance sheet and debt load untenable; and vast numbers of business strategies -- crafted in altogether different financial and economic times -- much less viable. Some companies will make the necessary adjustments and many will not. The unfolding backdrop definitely makes a lot of stock buyback plans imprudent and growth strategies highly risky. The aggressive risk-taking business manager -- having previously capitalized on the protracted boom -- will now be at a similar handicap to that which afflicted the zealous home buyer and lender.

For those searching for explanations behind the stock market's dismal start to the New Year, I suggest contemplating the many serious ramifications of the mortgage crisis having now evolved into an incurable corporate debt crisis. This week, the bursting credit bubble passed another significant inflection point -- one perhaps subtle but with major economic consequences.


Walter Schloss is truly, and literally, an old-school value investor. In theory his approach can be followed by anyone. You just need patience and discipline. Hair-trigger screen watchers need not apply. Forbes has done us all the favor of getting him to share his latest thoughts.

Walter Schloss has lived through 17 recessions, starting with one when Woodrow Wilson was President. This old-school value investor has made money through many of them. What is ahead for the economy? He does not worry about it.

A onetime employee of the grand panjandrum of value, Benjamin Graham, and a man his pal Warren Buffett calls a "superinvestor," Schloss at 91 would rather talk about individual bargains he has spotted. Like the struggling car-wheel maker or the moneylosing furniture supplier.

Bushy-eyebrowed and avuncular, Schloss has a laid-back approach that fast-money traders could not comprehend. He has never owned a computer and gets his prices from the morning newspaper. A lot of his financial data come from company reports delivered to him by mail, or from hand-me-down copies of Value Line, the stock information service.

He loves the game. Although he stopped running others' money in 2003 -- by his account, he averaged a 16% total return after fees during five decades as a stand-alone investment manager, versus 10% for the S&P 500 -- Schloss today oversees his own multimillion-dollar portfolio with the zeal of a guy a third his age. In a day of computer models that purport to quantify that hideous and mysterious force called risk, listening to Schloss talk of his simple, homespun investing methods is a tonic. "Well, look at that," he says brightly, while scanning the paper. "A list of worst-performing stocks."

During his time as a solo manager after leaving Graham's shop, he was a de facto hedge fund. He charged no management fee but took 25% of profits. He ran his business with no research assistants, not even a secretary. He and his son, Edwin (who joined him in 1973), worked in a single room, poring over Value Line charts and tables.

In a famous 1984 speech titled the "The Superinvestor of Graham-and-Doddsville", Buffett said Schloss was a flesh-and-blood refutation of the Efficient Market Theory. This hypothesis holds that no stock bargains exist, or at least ones mere mortals can pick out consistently. Asked whether he considers himself a superinvestor, Schloss demurs: "Well, I don't like to lose money."

He has a Depression-era thriftiness that benefited clients well. His wife, Anna, jokes that he trails her around their home turning off lights to save money. If prodded, he will detail for visitors his technique for removing uncanceled stamps from envelopes. Those beloved Value Line sheets are from his son, 58, who has a subscription. "Why should I pay?" Schloss says.

Featured in Adam Smith's classic book Supermoney (1972), Schloss amazed the author by touting "cigar butt" stocks like Jeddo Highland Coal and New York Trap Rock. Schloss, as quoted by Smith, was the soul of self-effacement, saying, "I'm not very bright." He did not go to college and started out as a Wall Street runner in the 1930s. Today he sits in his Manhattan apartment minding his own capital and enjoying simple pleasures. "Look at that hawk!" he erupts at the sight of one winging over Central Park.

One company he is keen on now shows the Schloss method. That is the wheelmaker. Superior Industries International (SUP) gets 3/4 of [its] sales from ailing General Motors and Ford. Earnings have been falling for five years. Schloss picks up a Value Line booklet from his living room table and runs his index finger across a line of numbers, spitting out the ones he likes: stock trading at 80% of book value, a 3% dividend yield, no debt. "Most people say, 'What is it going to earn next year?' I focus on assets. If you don't have a lot of debt, it's worth something."

Schloss screens for companies ideally trading at discounts to book value, with no or low debt, and managements that own enough company stock to make them want to do the right thing by shareholders. If he likes what he sees, he buys a little and calls the company for financial statements and proxies. He reads these documents, paying special attention to footnotes. One question he tries to answer from the numbers: Is management honest (meaning not overly greedy)? That matters to him more than smarts. The folks running Hollinger International were smart but greedy -- not good for investors.

These quantitative criteria are easy to screen for. Ascertaining a company management's integrity is more subjective, and thus trickier. Checking their compensation schedules in the most recent proxy statement is a start.

Schloss does not profess to understand a company's operations intimately and almost never talks to management. He does not think much about timing -- am I buying at the low? selling at the high? -- or momentum. He does not think about the economy. Typical work hours when he was running his fund: 9:30 a.m. to 4:30 p.m. ...

Not thinking "much" about timing, where the market is, the economy, etc. certainly has the virtue of freeing up energy to concentrate on the stock picks themselves.

Schloss owns a prized 1934 edition of Graham's Security Analysis he still thumbs through. Its binding is held together by three strips of Scotch tape. In the small room he invests from now, across the hall from his apartment, one wall contains a half-dozen gag pictures of Buffett (the Omaha sage with buxom cheerleaders or with a towering stack of Berkshire Hathaway (BRKA) tax returns). Each has a joke scribbled at the bottom and a salutation using Schloss's nickname from the old days, Big Walt.

Schloss first met that more famous value hunter at the annual meeting of wholesaler Marshall Wells. The future billionaire was drawn there for the reason Schloss had come: The stock was trading at a discount to net working capital (cash, inventory and receivables minus current liabilities). That number was a favorite measure of value at Graham-Newman, the investment firm Schloss joined after serving in World War II. Buffett came to the firm after the Marshall Wells meeting, sharing an office with Schloss at New York City's Chanin Building on East 42nd Street.

Schloss left the Graham firm in 1955 and with $100,000 from 19 investors began buying "working capital stocks" on his own ... Success drew in investors, eventually rising to 92. But Schloss never marketed his fund or opened a second one, and he kept money he had to invest to a manageable size by handing his investors all realized gains at year-end, unless they told him to reinvest.

In 1960 the S&P was up half a percentage point, with dividends. Schloss returned 7% after fees. One winner: Fownes Brothers & Co., a glovemaker picked up for $2, nicely below working capital per share, and sold at $15. In the 1980s and 1990s he also saw big winners. By then, since inventory and receivables had become less important, he had shifted to stocks trading at below book value. But the tempo of trading had picked up. He often found himself buying while stocks still had a long way to fall and selling too early. He bought Lehman Brothers (LEH) below book shortly after it went public in 1994 and made 75% on it in a few months. Then Lehman went on to triple in price.

Still, many of his calls were spot-on. He shorted Yahoo and Amazon before the markets tanked in 2000, and cleaned up. After that, unable to find many cheap stocks, he and Edwin liquidated, handing back investors $130 million. The Schlosses went out with flair: up 28% and 12% in 2000 and 2001 versus the S&P's -9% and -12%.

The S&P now is off 15% from its peak, yet Schloss says he still does not see many bargains. He is 30% in cash. A recession, if it comes, may not change much. "There're too many people with money running around who have read Graham," he says.

It is a strains one's credulity to think there was no timing involved in the Yahoo/Amazon shorts. If you shorted those stocks too soon during the dot-com bubble you got killed. The 30% cash position may smack of a market call, but is rather the outcome of not finding "many bargains". It would be interesting to discover why Schloss does not add more to stock positions he already holds. Perhaps they are "holds" but not "buys".

Nevertheless, he has found a smattering of cheap stocks he thinks are likely to rise at some point. High on his watch list (see table) is CNA Financial, trading at 10% less than book; its shares have fallen 18% in a year. The insurer has little debt, and 89% of the voting stock is owned by Loews Corp., controlled by the billionaire Tisch family. He says buy if it gets cheaper. "I can't say people will get rich on it, but I would rather be safe than sorry," he says. "If it falls more, I won't worry about it. Let the Tisches worry about it."

Schloss flips through Value Line again and stops at page 885: Bassett Furniture, battered by a lousy housing market. The chair- and tablemaker is trading at a 40% discount to book and sports an 80-cent dividend, a fat 7% yield. Schloss mutters something about how book value has not risen for years and how the dividend may be under threat. His call: Consider buying when the company cuts its dividend. Then Bassett will be even cheaper and it eventually will recover.

If only he had waited a bit to buy wheelmaker Superior, too. It has been two years since he bought in, and the stock is down a third. But the superinvestor, who has seen countless such drops, is philosophical and confident this one is worth book at least. "How much can you lose?" he asks.


An interesting comparison between two major-name U.S. retailers, Sears and Toys "R" Us. Many managements, particularly financial engineers and young people fresh out of business school, labor under the illusion that you can actually run a business or division by the numbers -- so much pushing of buttons as it were. This is never the case. Even in a textbook commodity business there are still employees, who are people. Numbers are a necessary part of managing a business, but that is all. Management vision matters.

Back in 2005, both Sears and Toys "R" Us were down on their luck and in danger of permanently losing relevance with their customers. Both were bought by financial firms, Sears by the hedge fund ESL Investments, controlled by Edward Lampert, and Toys "R" Us by a group that includes Kohlberg Kravis Roberts & Co., Bain Capital and Vornado Realty Trust. That is where the similarities end.

At Toys "R" Us, the new owners installed Gerald Storch as chief executive and gave him the leeway to do his job. Storch, a former Target executive known for his merchandising skills, carved out a niche for Toys "R" Us that got it out of Wal-Mart's direct path. He added more exclusive merchandise, improved customer service and renovated stores. The result? Toys "R" Us is on track to report a great year -- despite all the toy recalls that have ravaged the industry.

Granted, with $13 billion in sales (compared with Sears's $50 billion) Toys "R" Us is a less complicated turnaround. Even so, at Sears, things have turned out differently. Lampert, who has barely disguised his disdain for retail executives, has not hired the talent to get the job done. Sales are declining and profits are shrinking. After two years of experimenting with various strategies to revive Sears, Lampert is once again shaking things up. ...

The management shakeup comes one week after Sears said it would divide itself into five business units, in an attempt to make managers more nimble and accountable. ... What Sears needs, most observers agree, is some serious merchandising talent in the senior ranks, but "Eddie doesn't have a lot of respect for merchants," said one person who has worked with him. "He'd rather hire a young kid from Goldman Sachs or General Electric and teach them about the business."

For those who still believe that a break up is in the works, here's what another associate of his has to say about Lampert's ambitions: "Eddie wants to reinvent retailing -- he wants to show everyone how it can be done."

Here is one tip for success: Hire Gerald Storch. ... Hire talented people who understand retailing and let them do their jobs. ... Great retailers have a vision that permeates every aspect of their business. Sears still has credibility in hard lines. Make it THE place to shop for washing machines, refrigerators, lawnmowers and tools. Back up great products with unparalleled customers service. Invest in the stores.

Lampert is right that investing for the sake of investing makes no sense. But once you have the right people and strategy in place, you then have to put money behind your ideas.

One warning here: If some company tells you that a fundamentally lousy business can be turned into a silk purse by "good management", forget about it. As Warren Buffett once opined, if a great set of managers takes charge of a bad business, it is the reputation of the business that will remain intact. But the retailing industry, as competitive as it is, is huge and diverse enough that management can make the difference between good and bad results.


The credit squeeze, which seemed brutally bad only a few months ago, is getting worse.

In normal times, the cash and securities line on the balance sheet gets almost no attention. Everything else is subject to some guesswork, and/or some deviation between accounting rules and market reality. But cash is cash, right? However, when a credit bubble suddenly starts to deflate, it is no longer a given that all those slightly exotic forms of "cash" that corporate treasurers invested in to get a couple of extra basis points of yield are necessarily worth 100 cents on the dollar. With peak audit season at hand, now auditors are hard at work figuring out whether and where this is so.

As this year's audit season moves into high gear, auditors are spending more time than ever on what would seem to be the most mundane and easily verifiable assets on any company's balance sheet: cash and marketable securities.

"It is not just banks," Samuel A. DiPiazza Jr., the global chief executive of PricewaterhouseCoopers, said this week, speaking of the challenge facing auditors in determining the market value of financial assets for which there is no real market.

Mr. DiPiazza, talking to reporters over dinner, even raised the possibility of an auditor's challenging the value of a money market fund held by one of its corporate clients, saying that a statement sent out by a fund sponsor might not be enough to prove an investment was worth the stated amount. Instead, the auditor might need to look at the securities held by the fund, and judge their market value. "This will be challenging," he said of the auditors' responsibility to determine if companies are posting reasonable values for illiquid securities. "You are dealing with subjective judgments on valuations."

This is important not just because there could be more write-downs similar to the $275 million impairment charge taken last week by Bristol-Myers Squibb, but also because the very fact that auditors are asking questions is likely to make companies more reluctant to invest money in any but the safest assets.

During easy money periods, companies treating their non-operating assets portfolios as "profit centers" becomes fashionable. When money subsequently gets tight and losses and writedowns show up, corporate financial departments see the wisdom in leaving gambling to the professionals and go back to focusing on the areas where they have a genuine competitive advantage -- like formulating and producing pharmaceuticals.

"We have switched the portfolio," Andrew Bonfield, Bristol-Myers's chief financial officer, said when the write-off was announced. "As of today's date," he said, about 60% of the "cash and marketable securities is in T-bills and T-bill-related funds."

The company had treated so-called auction rate securities as short-term marketable securities, a category of assets that investors usually treat as equivalent to cash. Even though the securities were long term, there were auctions every month to set the interest rate, and to provide holders the opportunity to sell. But there are not enough buyers in the auctions these days, and some investment banks that marketed the securities are not willing to buy them back. That leaves the outstanding auction-rate securities with whoever owned them when the market closed. And it leaves companies that would like to issue such securities with one less source of available financing.

The credit squeeze, which seemed brutally bad only a few months ago, is getting worse.

Consider Solutia, a chemical company that filed for bankruptcy back in 2003, and got bankruptcy court approval for an exit plan just three months ago. That plan was based in part on a financing commitment for $2 billion from Citigroup, Goldman Sachs and Deutsche Bank. That commitment was signed in late October, but now the banks say the market has gotten worse and they will not make the loans. Solutia sued the banks this week, trying to force them to fork over the money even if they cannot sell the loan to others, as they had intended to do. Citigroup says the suit is without merit.

Regardless of how that suit turns out, it is an indication of how much harder it has become to get financing for highly leveraged companies. In recent years, companies that ran into problems could almost always get loans to rescue them. Now they cannot. And that is before a recession hits most industries.

The number of corporate bankruptcies filed by leveraged borrowers so far this year is greater than the total filed in all of 2006 and 2007, Standard & Poor's Leveraged Commentary and Data reports.

If the number of bankruptcies in one month and change is greater than the previous two years, credit availability is indeed getting extraordiarily scarce.

The prospect of more bankruptcy filings raises fears that some credit default swaps will not be good, because some of those who wrote them -- taking a fee for guaranteeing that a company would not default -- might be unable to meet their obligations.

Such fears make lenders more cautious, just as they make corporate treasurers search for safety rather than the slightly higher yields that seemed so attractive only months ago. So both lenders and treasurers search for safety, and in the process increase the risk of more companies going broke.

This is happening even as the Federal Reserve slashes the cost of borrowing for those with very good credit. Low interest rates are of little use to those who cannot borrow at any rate.


No-money-down mortgages have a risk/reward profile similar to that of buying a stock plus a put option on the stock. The home buyer/investor could hold the house as long as he or she saw fit, but had the right to put it back the lender at the purchase price. When the perceived probability of a house's price ever falling was low, lenders tended to ignore this logic. Now that a house price falling below its purchase price is a widespread occurrence, however, buyers are not ignoring this logic.

As this Wall Street Journal article phrases it, sellers seemingly sold the put options without bothering to price them properly. This is an interesting way to synopsize the whole credit bubble: lenders selling underpriced puts to borrowers. In the case of residential mortgages, it as if the lenders priced at-the-money puts the same as they formerly priced 20% out-of-the-money puts. Not surprisingly, they found plenty of buyers.

Fitch Ratings, while telling investors ... to expect additional "widespread and significant downgrades" on $139 billion worth of subprime loans, has cited a new factor in their "worsening performance."

"The apparent willingness of borrowers to 'walk away' from mortgage debt," the analysts noted, "has contributed to extraordinary high levels of early default" on loans issued during the 18 months before the mortgage bubble burst. It expects losses to reach 21% of initial loan balances for subprime mortgages issued in 2006 and 26% for those issued in early 2007.

Such behavior, where not precipitated by willful fraud, shows that American homebuyers supposedly duped by their lenders are not so dumb. They are perfectly capable of acting rationally without political interference. While mortgage fraud has abounded in recent years, voluntary foreclosures are not by themselves evidence of a newfound irresponsibility on Americans' part. To be sure, until recently, mass-scale voluntary foreclosures were unthinkable. But markets have changed, and people are changing their behavior in response.

A decade ago, most people started off with enough equity in their homes to make foreclosure irrational from a financial standpoint. Consider: If you made a 20% down payment on a house, prices would have to fall by 20%, almost immediately, before you lost all your money and had much incentive to walk away. This scenario was unlikely, particularly since an independent appraiser had assigned a clear value to the home. Foreclosure was remote, absent a personal financial crisis, for another reason: Every month your mortgage payment would reduce your debt and increase your equity, giving you more room for prices to fall.

But over the past few years -- until last spring -- banks and the mortgage-backed securities investors who bought the loans the banks packaged were not demanding substantial down payments; they were happy with 5% or even nothing down. They also did not worry about whether or not borrowers were building up equity. "Interest-only" loans, quick mortgage refinancings to cash out any equity, and other inventions often led to just the opposite.

Now the bloom is off the residential mortgage-backed securities (RMBS) rose. And some borrowers, even those who can theoretically afford to keep their homes, realize they owe much more than what comparable houses in the neighborhood are selling for -- and think that prices will not rebound anytime soon. So they are walking away, according to anecdotal reports as well as recent statements by top executives of both Wachovia and Bank of America.

In most cases, once a homebuyer splits, the mortgage-securities investors are stuck with the loss. In some states, including California and Arizona, this provision is the letter of the law. In others, the bank forgives the balance of the loan -- a common practice that is unlikely to change now, given the criminal and civil investigations banks are already sweating through.

Essentially, mortgage-bond investors, seemingly unwittingly, sold homebuyers a put option, without properly pricing it, and now homeowners are exercising that option. Moreover, prime borrowers in many markets face the same incentives. Yes, this behavior is new -- but only when it comes to houses. Americans have long been able to cut their losses from bad investments and start over. It stands to reason that when the market made houses into yet another speculative investment, Americans would do the same.

This observation about the incentive to walk being independent of one's capacity to carry the mortgage loan is not just a talking point. Now it is not just a question of how many subprime mortages are going to default because the borrow can no longer afford the carrying costs. The question is what is the value of all mortgages, prime and subprime, where the underlying property value has fallen measurably below the purchase price minus the down payment.

Borrowers acted rationally in response to market forces and incentives during the bubble: Buy a house because prices always go up; you cannot lose. Many are acting rationally now: Mail the keys back and un-borrow the money, because prices are sinking fast while the debt is not. When the house was purchased not as a first home but as a rental investment, the decision is even easier.

Imagine: Politicians keep saying that Americans need protection from their big, bad lenders -- but that protection is already there. Of course, there is a price. Mortgage "walkers" will take a hit to their personal credit rating. Yet this once-forbidding punishment may be discounted. That is because, just as when markets change their behavior, people change, when people change their behavior, markets change also.

If hundreds of thousands of people with decent work histories are going to have less-than-stellar credit because of foreclosures this year and next, they will not suffer so much as in the past. Many walkers are going to want to buy houses again some day; and when they do, lenders are going to want to make money lending them money to do so (hopefully requiring a good down payment). Investors searching for yield likely will not bypass what could be a large pool of borrowers.

This rapid transformation shows that the continuing political hand-wringing over what to do about failed mortgages is not needed. It is beginning to dawn on lenders and their agents -- who assumed that borrowers who could afford to do so would make payments no matter what -- that they could be stuck owning hundreds of thousands of houses at a minimum. This realization will pressure the companies administering those mortgage loans to renegotiate more quickly with borrowers in cutting loan balances. ...

Nobody is going to debtors' prison. Nobody is going to have to toil for 30 years and sacrifice their kids' future to pay off burdensome loans that they are stuck with forever because they overreached. (Even if banks and mortgage administrators pursue judgments for post-foreclosure loan balances, there is always bankruptcy as a last resort.) As for Sen. Hillary Clinton and her proposed "moratorium on foreclosures": She may soon find that borrowers, not just lenders, are screaming to let them act within their contractual rights.


It seems that sovereign wealth funds are growing suspicious that they are have been designated the suckers du jour to buy overpriced junk from U.S. investment banks. Given how much junk the banks have been peddling for years, the only surprise is that it has taken them this long.

Earlier this week I chatted with a jet-lagged U.S. financier. Like many of his ilk, he is flitting around the Middle East and Asia trying to extract finance from sovereign wealth funds and other investment groups. His latest travels have delivered a surprise: Some funds are quietly getting cold feet about the idea of putting more capital directly into western banks, he says. "There is a backlash building," he muttered into a crackling cell phone.

This is striking stuff. In recent months, many equity investors have taken comfort from the idea that sovereign wealth funds could ride to the rescue of Wall Street, if not the City of London too. For as the subprime scourge has spread, U.S. policymakers have leant on the largest US banks to raise capital, almost at any cost. Consequently, they have passed the begging bowl around the sovereign wealth funds, with considerable success. Thus far $40-60 billion-odd worth of injections have been promised to groups such as Merrill Lynch and Citi, depending on how you measure the promises.

But having stepped into the breach so visibly late last year, some funds are now getting jitters. In China, for example, there are rising complaints that funds are foolish to shovel cash directly into risk-laden U.S. banks when they could be using it in better ways, such as purchasing western commodity or manufacturing groups. "The Chinese are worried they are turning into [the source of] dumb money," says one well-placed Asian financier, who partly blames the trend on the Blackstone saga, which produced significant paper losses for the Chinese investors.

Meanwhile, in the Middle East, the latest round of Federal Reserve interest rate cuts has created unease. For sure, some powerful Gulf investors have been heartened to see that the U.S. authorities are acting in a resolute way. They are doubly relieved that the dollar has held up so well so far. But the dramatic scale of Fed cuts has prompted concern that Wall Street is still sitting on a putrid mess -- contrary to what the U.S. banks told the sovereign wealth funds late last year.

Unsurprisingly, this leaves Gulf investors cynical about promises from Wall Street banks. It also has some Asian and Gulf funds concluding that if they are going to invest to take advantage of the subprime mess, they are foolish to do so directly or alone. Hence some are now turning to private equity funds ... Private equity firms such as JC Flowers are at least trained to analyze the subprime mess.

Now, it would be nice to think this sentiment shift does not matter too much for the U.S. banks. After all, the recent infusion of funds means the largest Wall Street groups are looking pretty well capitalized on paper. It also means they should be able to absorb subprime losses, which banks such as Goldman Sachs think could reach $200 billion for the banks soon.

However, the problem is that subprime is just one of several potential looming shocks. Defaults on other forms of consumer debt and commercial property could rise this year. So could defaults on corporate leveraged loans from 2009 on.

Meanwhile, the monolines insurers are threatening to blast another hole in banks' balance sheets. Indeed, if you tot up all the hits that could emerge in the next couple of years, it is easy to reach a sum of $500 billion, or far more. This is sizeable, given that Goldman Sachs calculates that the banks' capital is around $1,600 billion.

I would bet that in the coming weeks large western banks will once again start passing the begging bowl around the Middle East and Asia. But I would also bet that these banks will find the going increasingly tough.

Yes, U.S. political pressure might produce a bit more money for banks. The Gulf and Asia remain flush with cash. But if the sovereign wealth fund money is now flowing to private equity funds instead of western banks, this gives this tale a whole new twist. Stand by to see a new chapter unfold in this financial crunch.