The Economy's Worst Is Still Ahead of Us

A year ago, Wall Street hotshots were living high on the hog, lying to and deceiving investors out of billions of dollars.

And now, they're getting what they deserve.

Lehman Brothers is out of business. Merrill was lynched. Bear Stearns is hibernating. Banks have folded. Jobs have been lost. Consumers have stopped spending. And the global community has suffered.

And now government officials and Wall Street are scrambling to fix what they began, throwing hundreds of billions of dollars at the very CEOs who contributed to the mess.

But who didn't see this coming?

Nouriel Roubini, a New York University professor who has emerged as a leading commentator during this financial crisis, predicted this would happen for years.

But no one listened.

Roubini tried to tell fellow economists at a September 2006 International Monetary Fund meeting that a crisis was coming... that a once in a lifetime tsunami would crush the U.S. economy, that consumers would stop spending, and that the country would face recession.

Still, no one listened.

Instead, the Street dismissed warnings that subprime mortgages would trigger a financial meltdown, as well as views that Fannie Mae and Freddie Mac would collapse, that investment banks would suffer, and that the global community was headed toward a long recession.

Even Hank Paulson, who in 2007 said "we're at or near bottom" for housing again... and again, ignored it.

And he's now eating those words, wasting billions trying to fix it.

Even "depression expert" Ben Bernanke dismissed subprime views:

We have spent a bit of time evaluating the financial implications of the subprime issues, tried to assess the magnitude of losses, and tried to determine how concentrated they are," said Bernanke in 2007. "There is a sense that, although there is always a possibility for some kind of disruption ... the financial system will absorb the losses from the subprime mortgage problems without serious problems." He also said he didn't expect the subprime problems to have significant spillover to the rest of the economy.

Still, I wasn't buying it, and wrote the following against Bernanke's and Paulson falsities in February 2007.

Truth be told, when it comes to an "improving" housing market, do yourself a big favor. Ignore the mainstream press, and Wall Street hot shots that would have you believing in a housing bottom, or the illusion of priced in lending weakness.

Among the worst hit lenders are the sub prime lenders, or those companies that make loans to borrowers with less than perfect or poor credit histories. While subprime lenders charged higher interest (two or three points higher than prime lenders) as insurance for the higher risk the borrower represented, rising foreclosures have left the sub-prime industry facing substantial fallout risks.

Subprime lenders could offer adjustable or teaser rates to those with bad credit. Loans like this made up 23% of the U.S. mortgage market in 2006 as compared to the 8% in 2001, according to Yahoo News. And it's now a big problem as one in five sub-prime mortgages are now ending in foreclosure, according to the Center for Responsible Lending as mentioned by Yahoo News.

The Lending Market has not bottomed... nor has it priced in all negativity.

I'd love to sit here and jump on the bullish housing bandwagon that dominates Wall Street. Really, I would. But I'm not a fan of flushing my money down the toilet.

In reality, the housing market has not bottomed. Subprime lenders are doomed. You can continue to listen to the delusional madness pouring from the mouths of Street analysts, and the mainstream press, or you can listen to the homebuilder CEOs and the subprime lenders that have gone belly-up because of a weak housing market.

It's your choice. But I'd go with the latter, though.

That's just an inkling of the tumultuous future for subprime lending.

But one thing's for certain - the worst is not over for subprime lenders, Alt-A, homebuilders, banks, retailers, consumers, and the global community.

Rest assured, no one's ignoring Roubini any more.

While the market looks to rally near-term, creating value opportunities for beaten down, undervalued stocks, here's what many people haven't been talking about... Option ARM resets.

Why Roubini Thinks Things Will Get Worse

Roubini is now predicting that hundreds of hedge funds will go belly up and stock markets may have to shut down for up to a week to stem global panic selling.

But for all of his predictive successes, critics still urge calm.

Instead, those that criticized Roubini's last prediction now believe he's nothing more than a "doom-monger" who crowed about recessionary fears even as the economy boomed.

But, says Roubini, "These crises don't come out of nowhere. Usually they arrive because of a systematic increase in a variety of asset and credit bubbles, macro-economic policies and other vulnerabilities."

So what do current indicators tell him? An end is not in sight.

"Every time there has been a severe crisis in the last six months, people have said this is the catastrophic event that signals the bottom. They said it after Bear Stearns, after Fannie and Freddie, after AIG..." and after $700 billion bailout plan.

"Each time they have called the bottom, and the bottom has not been reached."

Here's What No One's Talking about... Yet

If you thought the first leg of the credit crisis has been bad...

Wait until the mountainous Option ARM loans begin resetting... and the second leg of the credit crisis begins.

Alt-A loans were given to borrowers with credit scores of between 620 and 700, and included the option of interest-only loans, option ARMs, and no documentation loans that required little if any documentation for loan approval. Ninety percent of those that got an Option ARM in 2006 provided little or no documentation.

Ninety percent!

And it's estimated that only 60% of Option ARM borrowers make only minimum monthly payments. Others estimate that up to 80%.

Say a borrower makes minimum payments on a $600,000 loan. That loan could easily be a $750,000 loan within two years.

Stock position: None.

Comments

[Demetri:]

I would like to see data on balloon mortgages from 2006-2007. I suspect they will not be able to pay off the balance nor will they be able to re-fi.

2008 Nov 04 06:20 AM

[Doug Poretz:]

I agree with all the above, but will take it a step further. Since Post World War II, this nation has been innundated with "buy this" messages, and, as a result, adopted a materialistic culture. It was that culture that gave rise to the economic situation described in your comments. But it gave rise to other things as well: our politics, our entertainment, our life styles. The consumer, for all practical purposes, is dead for a while (OK: comatose). The traditional advertisers will seek greater effeciency for their dollars, and they will take their messages to those distribution channels that go straight to their targets. At the same time, the political change that is about to occur in the US (and the world), is going to cause the emergence of a massive amount of "support this" messages -- brought to you by the special interest groups of all ilks, sizes, persuasions and motivations that will need to defend against changes that could change the rules of their game (as well as promote some changes that can make their game better). Ultimately, there will be a cultural change. I think it is way too early to predict what that culture will look like. But I do not think it is too early to predict that some old business models are going to fail -- for example, in my business, the communications business. If interested, I write about that at my blog, which is linked above.

2008 Nov 04 08:57 AM

[David Martin:]

Fine analysis.
The Alt-A mortgages have to be so far underwater that they are submarines, as most mortgages which do not carry over interest are well below sale value.
From the figures you give, on a $600k house with interest you might owe $750k for an asset with $450k of value.
That takes down the mortgagee, the bank and the derivative market, together with the bail out plan scam.

2008 Nov 04 09:31 AM

[Smarty_Pants:]

Let's not forget the other shoes waiting to drop:

1) Commercial real estate
2) Auto loans
3) Credit card debt

Each of these will undergo the same problems that residential real-estate is experiencing now. Expect many more Billion dollar writedowns to follow.

"It ain't over till it's over" - Yogi Berra

2008 Nov 04 11:43 AM

[Kirk Miles:]

Thank you for your interesting piece about how the market has not reached its bottom. It is interesting to see how often Wall Street is dominated by a group think mentality. I feel that all it takes for a temporary spike in the stock market is for a handful of analysts to come out with a positive outlook on the market and everyone else will buy into it. Are these people not supposed to be some of the brightest in the country? Are they incapable of looking at some of these facts and realizing that, although we do not know exactly when the market is going to turn around, it probably is not at this exact moment? Looking at the past week, it is shocking to see how irrational the market has been. Consumer confidence fell to an all time low (almost 15 points below the Street’s estimate) and yet the market rallied nearly 900 points. Additionally, the United States GDP declined for the first time since 9/11 and real consumer spending fell for the first time since 1991, and the most since 1980. I am not sure which part of this news indicates to investors that the market has bottomed out.

If what you and Roubini say is true, and that hundreds of hedge funds will go belly up and the Option ARM loans result in a second financial crisis, those optimists are in for a rude awakening. On that note, I wish you had gone into greater detail about why the hedge funds are going to fail or when the Option ARM loans are going to begin resetting. The prediction that the hedge funds will go belly up loses some of its credence when you do not back it with any reasoning, only repercussions. You explained the Option ARM loans well, but by not including an idea of when to expect that crisis to begin, all you did is raise my blood pressure. However, those two do not take away from the fact that this was an eye opening piece about where the market has the potential to go. I am hoping none of your predictions come true, but look forward to continuing reading your blog in the future.

2008 Nov 04 02:37 PM

[Kunst:]

Smarty_Pants: One more, a big one: state and local governments. Revenues are dropping, unemployment costs are rising. The squeeze is going to be intense, leading to reduced services including government employee layoffs.

2008 Nov 04 09:51 PM

[Dean M:]

Like most peope I had no idea of the scope of the sub prime /alt a mess until I heard about it last year. But Bernanke and Paulson had all the data they needed to draw the correct conclusion. I don't know if it was a question of incompetence or lack of integrity that caused them to deny the problem for so long but they should both ride off into the sunset.

2008 Nov 05 01:14 AM

[O-B-WON:]

• A tsunami is not a single wave but a series of waves, also known as a wave train. The first wave in a tsunami is not necessarily the most destructive. Tsunamis are not tidal waves.

We've had the first financial tsunami.... how many more.... and how big..???

....most people aren't even aware of what's about to occur....

2008 Nov 05 04:14 PM