The Rude Awakening
Laguna Beach, California
Tuesday, August 7, 2007 ------------------------- - Equity dries up - Billions on hold and awaiting disaster,
- The subprime house of cards - This is just the beginning…
- T.V. journalism's leading contrarian indicator and more…
------------------------- Eric Fry, reporting from Laguna Beach, California… On July 16th, the Dow Jones Industrial Average registered a new all-time high of 13,951…and all seemed right with the world to the eager buyers of American stocks. On that same day, CNBC's shrill, "I-told-ya-so" commentator, James Cramer, dismissed the unfolding subprime mortgage crisis as "meaningless." But two weeks later, as the Dow was tumbling 284 points, Cramer described the very same crisis as "Armageddon." What had changed? Only that the Dow had shed almost 1,000 points.Fortunately for Jim Cramer, he is paid good money to be an overly emotional and overly reactive Everyman. Most investors are not so lucky. Most investors have to make (or lose) their money in the real world - not in the world of "I-told-ya-so" TV journalism. Most investors, therefore, do well to pay attention to extremes of fear and greed. When folks like Jim Cramer begin to scream a bullish point of view from the TV screen, investors should probably pursue an opposite course of action. And when he wails a bearish point of view, investors should probably consider buying a share or two. On July 16th, as the Dow was setting new record highs, Cramer declared, "Subprime…is totally meaningless. I am now saying that if every loan in 2006 that was subprime blew up - $500 billion - if they all blew up, you would still not notice…It has no relevance whatsoever." "The trancheing [sic] of this stuff is the reason why there's no impact," he continued, "because it's been divided and split among so many entities that no ONE entity is really being hurt, other than the dumb guy who ran Bear Stearns." On July 16th, most of the investment world agreed with Cramer's benign assessment. But just 18 days later - and 900 Dow points lower - Cramer offered a dramatically different assessment. "The Fed is asleep…We have Armageddon!" he screamed on the air. "In the fixed-income markets we have Armageddon!!" And so it seemed to the majority of investors on that day. The Dow tumbled nearly 300 points, while the price of protecting against falling share prices soared to multi-year highs. As the nearby chart illustrates, for example, the implied volatility of put options on Countrywide Financial (NYSE:CFC) tripled from what they had been just two weeks earlier. In other words, investors had become very, very afraid. 
"Implied volatility" is just a fancy way of saying: "the price of insurance." When share prices fall a lot, the price of protecting against an even bigger fall goes up. This tendency is hardly surprising. The price of fire insurance would skyrocket, for example, if your house were already on fire.
In the case of Countrywide, the implied volatilities were not merely high, but they were high in relation to the actual, historic volatility of the stock. In other words, the anticipated potential share price movement was about three times higher that the recent historical experience. 
If your eyes are glazing over, dear investor, we understand and empathize. But suffice to say that investors are paying far too rich a premium to protect against a drop in Countrywide shares. When fear reaches these extremes, rallies usually follow. When the price of protecting against falling share prices becomes very expensive (like it is currently), and when folks like Jim Cramer begin screaming about Armageddon, a rally is usually close at hand. On July 16th, Jim Cramer was very bullish, just like most investors. The Dow tumbled 900 points shortly thereafter. But on August 3, Cramer was panicking, just like most investors. The very next trading day, the Dow rallied almost 300 points. Armageddon may be drawing near, but it will not arrive until the day that Cramer declares Nirvana. --- Urgent: Special Resource Report --- "The Biggest Resource Breakthrough Since the 'Beaumont Miracle' of 1901" 64 publicly traded companies are already deeply invested… insiders are already raking in as much as $205,421 per day on the shares… But only one of these cutting-edge companies offers you the "secret wealth advantage" I reveal below… I urge you act quickly. I'll even front you the first $500… but only if I hear back from you by midnight Sept. 4…Read On Here For Your Full Report ---------------------------------------- The Bear Stearns Bust
By A. Gary Shilling Up until a month ago, most stock and bond investors were convinced that the subprime mortgage slime was a small isolated cesspool with its own peculiar financing that would be contained and have no meaningful effects on their rock-solid investments. Stocks were hitting new highs and junk bond spreads vs. Treasurys were at all-time lows. But no more. Complacency has been replaced by fear and foreboding. Since late June, when Bear Stearns was forced to bail out its subprime debt-laden hedge funds, we've seen global de-leveraging along with the drying up of all that liquidity that's been sloshing around the world and fueling speculation. The deal postponements and restructurings since the Bear Bust make it evident that the private equity buyout era may be over. Underwriters postponed $12 billion in debt sales as part of the Chrysler buyout by Cerberus. Financing of the buyout of U.K. drugstore giant Alliance Boots by Kohlberg Kravis Roberts has also been put off along with the loans to finance GM's sale of Allison Transmission to private equity firms. In just the week of July 22, the financing of eight major deals was postponed. Then there was the calling off of sales of $3.6 billion in leveraged loans and junk bonds to finance the LBO of US Foodservice and the $1.15 billion junk bond financing for ServiceMaster. Online travel agency Expedia planned a buyback of 42% of its stock. The stock took off on the buyback announcement, but tanked later when lenders balked and the repurchase was cut to 9%. The potential sale of Cadbury Schweppes' $15 billion U.S. soft drink business is on hold as is the sterling-denominated bond issue of U.K. mobile phone retailer Carphone Warehouse. Takeover firms themselves are in trouble as they drop their "private equity-is-best" credo and go public. Investors who bought Blackstone stock at its initial $31 per share are way under water and those who invested in online travel firm Orbitz, which Blackstone took public on July 20, lost about 20% in the first eight trading sessions. With sinking junk debt markets closing off the private equity boom, KKR's planned IPO will probably be postponed or cancelled. It's also not surprising that a number of highly leveraged hedge funds were caught by the Bear Bust. Sizable losses have been reported by Old Hill Partners and Wharton Asset Management. United Capital, with $500 million in assets, has stopped investors from withdrawing capital while Braddock Financial is closing its subprime mortgage-ladened Galena Street Fund and suspending redemptions until it can sell its $300 million holdings. London-based Caliber Global Investment got nailed in American subprime mortgage holdings and is closing after losing 53% of its $2 billion value. And in Boston, Sowood Capital Management announced that it lost over 50% of its $3 billion assets and is closing its two funds. Troubles in subprime mortgage land has been well known since the beginning of the year. But with the Bear Bust, investors began to worry about the A, AA and AAA tranches. Then came the shocking announcement on July 24 by Countrywide that delinquencies of 30 days or more on its subprime loans leaped to 23.7% at the end of the second quarter from 15.3% a year earlier. A big jump, but no big surprise. But on prime home equity loans, delinquencies leaped to 4.6% from 1.8%. So the subprime slime has oozed up to the high rent district! Propelled by loss provisions and write-downs of securities backed by those prime home equity loans, Countrywide's net income slid 33% from a year earlier and the stock tanked. And note that many of those Countrywide loans were piggybacks, loans on top of first mortgages that often bring total borrowing close to 100% of a house's value. It was only with the Bear Bust that stockholders began to realize how dependent equity prices are on junk securities. Debt markets have propelled stocks. Clearly, profits growth, which is slowing dramatically, is no longer the primary driver and interest rates, another important determinant of stock prices, haven't declined enough yet to provide significant support. Stock buybacks are often financed with junk bonds. According to Federal Reserve figures, nonfinancial corporations removed $128 billion in stocks from the market in the first quarter and issued $130 billion in new debt. Buybacks put fresh buying power in shareholders' hands and they've leaped, with $157 billion announced in the second quarter, up 58% from a year earlier. Private equity buyouts, primarily financed with junk securities, also have been a key propeller of stocks. They also put money in shareholders' hands, and as an added bonus, encourage them to search for and buy the next likely LBO targets. Financial stocks have proved especially vulnerable to the Bear Bust, but not just the big banks involved with hedge funds, CDOs and junk securities. Regional banks have come under a cloud as the value of their construction loans is questioned. So is the worth of the low-quality mortgage loans they hold. Homebuilder stocks have been in the doghouse and about to slip below book value, which itself is falling as writeoffs of unneeded land and other assets add to net worth-depressing operating losses. And as far as mortgage lenders are concerned, they continue to leave the business one way or another with gay abandon. The latest was American Home Mortgage Investment Corp., a large REIT that specializes in prime and near-prime loans and accounts for 2.5% of the U.S. mortgage market. On July 31, it said it can no longer fund home loans and may liquidate assets. Its stock promptly dropped 87%. This is clear evidence that credit markets are tightening as lenders, after the Countrywide bombshell, fear that the subprime slime is moving to the prime arena. I foresee a 25% peak-to-trough decline in median single-family house prices nationwide. Remember, the earlier leap in prices was so exuberant that it would take a 50% fall to return them to the post-World War II norm, after adjusting for inflation and the increasing size of houses. I'm also forecasting a 60% peak-to-trough decline in existing house sales-a forecast that many view as extreme. But between November 1978 and May 1982, sales fell 55% in what was a much less severe housing slump than is ongoing today. The global recession that I expect to result from the spreading subprime slime, global de-leveraging and speculative bubble-breaking will benefit stocks by reducing inflation fears and thereby Treasury yields, aided by the usual Fed ease. But as is normal early in the recession, plummeting profits will more than offset those salutary effects to the detriment of stocks. Stocks at home and abroad are suggesting that worldwide problems lie ahead. Meanwhile, the leap in expected stock volatility indicates a newfound appreciation for investment risk, another drag on equities. I suspect that a full-blown bear market is starting, or soon will. [Joel's Note: It seems not a day goes by without another foreboding headline zipping across the screen. When Wall Street's suits are postponing deals, holding back offers and even shutting up shop, you can be sure it's going to be a lot worse for the little guy at the end of the chain. 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