The ominous clouds that have been lurking on the horizon have yet to materialize in the darkest forecasts imaginable, and the repeated commitment of the government to bail out the financial institutions at the crux of these issues makes me start to wonder if maybe we will be able to avert disaster through psychology, inflation, or some other means.

Someone with a contrary view is Nouriel Roubini of New York University’s Stern School of Business, who suggests that we are on a 12-step course to what he calls “The Mother of All Meltdowns” which he discusses in this article: America’s economy risks the mother of all meltdowns

Here are the 12 steps:

Step one is the worst housing recession in US history. House prices will, he says, fall by 20 to 30 per cent from their peak, which would wipe out between $4,000bn and $6,000bn in household wealth. Ten million households will end up with negative equity and so with a huge incentive to put the house keys in the post and depart for greener fields. Many more home-builders will be bankrupted.

Step two would be further losses, beyond the $250bn-$300bn now estimated, for subprime mortgages. About 60 per cent of all mortgage origination between 2005 and 2007 had “reckless or toxic features”, argues Prof Roubini. Goldman Sachs estimates mortgage losses at $400bn. But if home prices fell by more than 20 per cent, losses would be bigger. That would further impair the banks’ ability to offer credit.

Step three would be big losses on unsecured consumer debt: credit cards, auto loans, student loans and so forth. The “credit crunch” would then spread from mortgages to a wide range of consumer credit.

Step four would be the downgrading of the monoline insurers, which do not deserve the AAA rating on which their business depends. A further $150bn writedown of asset-backed securities would then ensue.

Step five would be the meltdown of the commercial property market, while step six would be bankruptcy of a large regional or national bank.

Step seven would be big losses on reckless leveraged buy-outs. Hundreds of billions of dollars of such loans are now stuck on the balance sheets of financial institutions.

Step eight would be a wave of corporate defaults. On average, US companies are in decent shape, but a “fat tail” of companies has low profitability and heavy debt. Such defaults would spread losses in “credit default swaps”, which insure such debt. The losses could be $250bn. Some insurers might go bankrupt.

Step nine would be a meltdown in the “shadow financial system”. Dealing with the distress of hedge funds, special investment vehicles and so forth will be made more difficult by the fact that they have no direct access to lending from central banks.

Step 10 would be a further collapse in stock prices. Failures of hedge funds, margin calls and shorting could lead to cascading falls in prices.

Step 11 would be a drying-up of liquidity in a range of financial markets, including interbank and money markets. Behind this would be a jump in concerns about solvency.

Step 12 would be “a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices”.

For me…once we get to step 9 or so, the connections between the dots start to become hazy. Although the “shadow” financial system is indeed a bit scary in some senses, it is unclear to me that there will be a fundamental collapse in said system barring some direct event. I am not saying that such a collapse is impossible; it is just such broad generalizations seem to come from the fear of the unknown more than anything else.

I guess what I am saying is that given the level of consciousness that is being brought to bear on the other major challenges that we face, that perhaps through collective innovation, or pure financial sacrifice, we may finally be able to stop the bleeding and carnage.

This article: Credit-Card Pinch Leads Consumers To Rein In Spending in the Journal Friday was spurred by a fall-off in consumer borrowing, which seems more reasonable in the current environment that what we saw last month and I discussed a few week ago.

A few friends and I had a healthy debate about what this means. Some suggested we are reaching a bottom…I disagreed. Here are my thoughts:

Consumers have already maxed out their credit cards. Judging from this Fed data: Consumer Credit data it looks like revolving credit hit a peak in November… (or look at any macroeconomic data on household debt-levels). There is just no more room for borrowing at the household level.

As incomes decline and the ARM’s continue to reset (yes, there are still billions of dollars worth of ARMs out there yet to kick in) more and more people will feel the pinch.

Couple this with the tightening credit, and they will no longer be able to roll-over their zero-percent introductory rate balances as their mini-consumer-ARMs kick in (nor will they have HELOC’s to supplement their spending habits).

And as defaults continue to rise on credit cards, this will only exacerbate the household crunch as late-payment penalties and ridiculous APR’s kick in. (note: in my mind these people in the article should file for Chapter 7).

And that is before taking into account the job losses from: mortgage origination firms, mortgage brokers, home builders, home-suppliers, wood processing firms, construction workers, investment bankers, etc. etc.

A scary statistic I heard recently: the median LTV for homeowners filing for bankruptcy thus far in 2007 is 90%. Think about that…that is on the “market value” of the home as they headed into bankruptcy, not on the value as it has declined since then. Projecting one year out, one can easily assume that the median distressed homeowner is underwater on their mortgage. This paints a pretty clear picture of continued overhang in the residential real estate market (ignoring the ridiculous squeeze on mortgage credit which further crimps demand).

The latest word amongst those with half-a-brain is that the housing market won’t bottom until 2010.

I think Buffet mentioned today that in his opinion it isn’t so much that there is a credit-tightening going on as much as a repricing of risk. Stupid money isn’t as available in plenty as the leverage has been sucked out of the system from collapsing CDO’s and SIV’s (not to mention the rising default rates in consumer finance of all shapes and sizes)…oh, and don’t forget the CLO/Leveraged loan market.

I am a little more bearish than Danny’s new friend, Warren, (I think this IS a tightening of credit in addition to a repricing of risk as asset values force us to collectively “mark-to-market” at values below our underwriting, forcing collective liquidations), but then again, he is smarter than me.

So take your pick on what you want to see as the driver but the reality is: consumer spending is going to continue to decline.

That said, I am a bull on technology. There will be some cool gadgets and sweet toys in the world once we get out from under this cloud.

CDO Market Is Almost Frozen, JPMorgan, Merrill Say

For some reason this headline made me think of a brutal game of musical chairs where the music stops and the players are left with the option of jumping on a bed of nails or being kicked teeth first into the curb on the Street.

The never-ending slew of headlines on the deteriorating credit quality of these instruments only makes it more starkly obvious that the credit ratings placed on billions of these things were absolutely worthless.

Moody’s virtually acknowledged as much today (see this article) by suggesting that it might adopt a set of “warning labels” for their ratings! The fact that their rating methodology is so suspect that they have to create the equivalent of a skull and crossbones would be laughable if it weren’t so scary in its implications. In other words, Moody’s is saying “you know those $billions of securities we said were ‘AAA’…well…we didn’t reallly mean it”.

If the CDO market already froze up before such an acknowledgement, where do we go from here? What is the next market to freeze?

Maybe the murmurs in the leveraged loan markets will become full-fledged wails when the buyers in that market start to question the promise for their exit alternatives in a drying liquidity environment. What about CDS markets that actually have to consider counter-party credit risk? Probably not as easy to trade this stuff willy-nilly once you realize your insurer may not exist tomorrow.

Life is beautiful, but it sure does have a bad hair day sometimes.

The world is really moving in an exciting direction notwithstanding of all of the recent madness in the markets. We are in the midst of what some are calling a “loss of privacy” on the one hand, while on the other hand we might instead call it “an improvement in information and transparency”.

Case in point: Bill Ackman, a notoriously bearish hedge fund manager, has recently written an open letter to the insurance regulators regarding his multi-year negative view on the bond insurance companies that have been in the headlines of late.

The coolest part of his letter is not only the public display of his thoughts, but also his sharing of what he is calling an “open source model” which he has made available for download and collaboration.

Take a look at the letter, some of which is quoted below:

Bill Ackman’s letter to insurance regulators

Our primary goal is to initiate what we call “Open Source Research” where all market participants can have equal access to the primary source data and construct their own views of losses without reliance on the analytical judgment of rating agencies or the bond insurance industry.

By focusing the discussion on a fundamental, data-driven approach, we expect that the dissemination of the Open Source Model will enable market participants and regulators to accurately estimate probable losses by relying on rigorous fundamental analysis of specific credit exposures, a departure from relying on the opaque, faith-based pronouncements that the bond insurance industry has promulgated to the marketplace.

In order to facilitate a comprehensive and accurate estimate of probable losses in the bond insurers’ exposures, we believe that you, as their regulators, must require the bond insurance companies to provide full disclosure to the market of their entire portfolio of insured exposures. This should include not only confirmatory data on CDO and related RMBS exposures detailed in the Open Source Model, but also municipal and other structured finance exposures, especially those exposures that have been or are in remediation, are rated below-investment grade, require claim payments or otherwise have been or are carried on so-called “classified watch lists.”

…

Only with a complete understanding of all of the bond insurers’ gross exposures to potential losses can the market gain a complete understanding of the insurers’ capital adequacy.

If the bond insurers truly believed that greater disclosure would help confirm the veracity of their loss estimates, one would have expected them to provide full transparency to the marketplace.

Download the model here – But be careful. This thing is huge (128mb) so it might destroy your system.

Thanks to WLH for sharing this.

This data from the fed makes me wonder what is going on with all the headlines suggesting that the economic slowdown is coming from hurting consumers.

January 10th Consumer Credit data

Sure, I get the logic: I am levered, I can’t afford my ARM, I can’t afford higher CC rates, so I can’t spend more.

But what does this rapid increase in revolving credit mean? I mean it popped 10% in November which is the most recent data available. Is this all increasing balances? It seems like it has to be the “Christmas shopping” season, which seems relatively strong at least in the sense that the consumer credit market remains open in a way that subprime lending is no longer available…

So does that mean that savings are tapped out and now people are just at the end of their rope?

Whatever it means, it sure doesn’t look pretty for the balance sheets of households across the country, but it sure does seem that people are willing to keep flashing the plastic to get some bling.

Any thoughts are appreciated on this one.

Have you ever seen a bird flying into its own reflection? For whatever reason, the impact of skull on glass does not seem to teach these otherwise brilliant (read: they can fly!) creatures not to keep doing the same thing over and over again.

Although Alan Greenspan has reluctantly admitted that perhaps he should have seen some of the potential impact of the excesses created in the real estate house of cards, those outside the Federal Reserve to seem to almost unanimously agree that it was Al’s wall street-friendly interest rate policy that allowed so many borrowers, from private equity firms to subprime home owners, to spend too much for assets over the last five years, leading to the repricing which is at the root of the current credit debacle.

So as the global equity markets started to recognize the gravity of the challenges facing our economy over the weekend, and it looked like the most sophisticated investors in the world – U.S. equity markets investors – were starting to follow suit with the S&P500 trading down over 4% in the futures market this morning, what did the Fed do?

What else but slam its head into the glass door of loosey-goosey lending (yes that is a technical term) by cutting the federal funds rate 75bps before the market opened this morning?

Like Bush’s proposed “bailout”, this was a move to change the psychology of the market, and perhaps it had its intended impact as the market avoided major losses with the major indices ending the day virtually flat.

However, this does not change the basic reality that we live in a world where asset prices have been overly inflated by excess liquidity and as the reality of the obligations that people have incurred comes to roost ugly things will continue to happen.

Just today the SF Chronicle reported on a dramatic 421.2 percent increase in foreclosures in Cali for the fourth quarter of 2007.

I don’t know about you, but I have become almost numb to the bad news coming out about the housing sector and not just because I have been paying attention for a long time. It has become as commonplace as the murder in the inner city, and it is not going away until we go through the healing process necessary to overcome the hangovers caused by the excesses of the recent past.

One of the greatest lessons that a parent can give a child in my opinion is to allow her to suffer the consequences for her actions, because someday in the real world, she will have to stand on her own two feet. For some reason, our Federal Reserve feels like it needs to baby those who made poor decisions in deploying capital over this last cycle with a bottomless basket of puts…but anyone who looks will see the glass door that we are banging our collective head into once again. Who knows, maybe if we close our eyes it will go away or better yet, maybe like the monster in Will Smith’s recent flick Legend if we bang our head hard enough the glass will break.

As the world markets plummet on MLK day here in the States, the worst-case scenario that I have worried about for a few years now seems like it may be starting to unfold.

For those who haven’t spoken to me on the topic, the basic idea goes like this:

When people enter CDS contracts, most of the time they don’t do much work on their counter-parties in terms of evaluating their credit. In other words, much like when you or I get flood insurance for our homes we don’t ask our insurance company for its financial statements to make sure they will have the cash if we need to draw on it, people who bought default protection in the CDS market often did not evaluate the credit-worthiness of their counterparties.

Some suggested to me over the last few years that this was not necessary because the entities they were trading with were AAA rated, or that they were AAA rated subsidiaries of other entities.

As it turns out, there was counterparty credit risk in these contracts, and it is starting to materialize…and the repercussions may be massive as the counterparty is unable to make good on his side of the insurance contract (for more on CDS, see my earlier post here: Crazy Derivatives Stuff).

Doomsday happens if banks have to step in and make these contracts whole because they were market-makers in facilitating the trades. Haven’t seen this piece of the pie emerge yet, so I am hopeful it does not. But being forthright about exposures has not been high on the list of qualities of U.S. financial institutions of late.

It appears that one institution alone, discussed here by Bloomberg, has more than $60B in CDS exposure that it just “can’t pay”. In other words, it is like you paid your insurance premiums on your flood insurance and then Katrina hit and Bam – they didn’t pay…and not because it was “wind” damage ;-).

ACA Customers Allow More Time to Unwind Default Swaps

The problem with this is that we are only the the beginning of the default cycle and if there are already these kinds of issues, this may set off a waterfall effect as commercial real estate, credit card and autoloan ABS, and corporate loan defaults start ticking up.

In other words: we ain’t seen nothin’ yet.

It seems like the twilight zone when stepping back and surmising the last year from 50,000 feet.

Last spring was one of the strongest bull markets in recent history, and the economy (and real estate market) was humming along with seemingly unbreakable speed.

Although the writing was on the wall for many of us, bringing profits in being ahead of the curve in shorting some of the worst offenders of the subprime crisis, most people thought we were doomsdayers and brushed us aside.

I remember vividly a number of conversations with friends who graduated from HBS in the Spring, which consisted of me trying to explain to them that we were headed into a seriously challenging economic situation and them nodding while their eyes said: “sure buddy…I’m off to my sweet consulting gig…you stay here and come up with more conspiracies”.

Now, just 8 months later, the fact that we are heading into an economic downspiral is of such consensus that Bush and Pelosi are having friendly jabber about it.

What started as a “put” through continued rate cuts has now become a full on economic bailout as the President and the Congress are working hand in hand to come up with what they are terming an “economic stimulus” package.

It is discussed further in this article: Bush Nears Plan That Economists Say May Boost Growth

The punch line is this: we are going to try to deficit spend just a little more to somehow buy our way out of a leverage-induced economic cyclical downturn.

My take: this is election year politics at its finest. $150B is peanuts to this economy in the first place, not to mention the fact that at a fundamental level this is perpetuating the kind of overly-leveraged fiscal policy at the household and country level that got us into this mess.

We borrowed too much, can’t pay our mortgages (and soon auto-loans, credit cards, commercial real estate loans, corporate loans, etc), so how do we fix this problem? Borrow more.

Unfortunately, I think something like this might be needed for psychological reasons (and on the campaign trail) if nothing else – we need to trick at least some people out there into thinking that things are going to be OK in the short run, as most of us are so myopic that long-run payoffs don’t register.

For those of us paying attention, as I mentioned in my last post, there are starting to be some opportunities to invest in strong companies for the rebound. Not to mention all of the super-sweet stuff happening in the world of technology.

There is hope on the horizon…but in the foreground let’s face the fact that there is more carnage to come.

Been awhile since my last post as I have been out of the country in Australia after a brief stop in Texas for the holidays.

Of course you all have noticed that the carnage has continued unabated and even those idiots who didn’t want to admit that the problems in the credit market would spread beyond “subprime mortgages” have now had to face the hard truth that we are in for a challenging environment in the credit markets and capital markets in general for some time to come.

I must admit, though, that the pessimism in the equity markets over the first couple of weeks in the year has had the bullish side of my psyche drumming its fingers and looking for cheap buying opportunities. Even financial stocks like CFC’s knight in shining armor BAC are starting to look somewhat interesting, as BAC is trading at over a 6% dividend yield right now and has just guaranteed itself the position of leading mortgage originator in the first half of the 21st century.

WAG has gotten so punished that it is trading at a reasonable ebitda multiple of just over 8x, and especially if you believe that our drug-addicted culture is going to produce fatter margins for complementary products sold in drug stores, as this dominant american franchise continues to have the prospect to enjoy the benefits one might start to take a closer look. I know I am.

Even the king of fake revenues through 0% financing and other shenanigans, GM, is so beat up that if one can get comfortable that GMAC is no worse than a zero (i.e. there is no liability there…I wish I knew more about this issue, but unfortunately, I don’t) there might be something there. We have to believe that the largest auto manufacuturer in the U.S. can somehow benefit from a weak dollar. At least to the tune of greater than a $32B enterprise value. Remember. GM’s revenues are over $180B. It should be able to convert SOME of that into profit. Assume 2% operating margins and you are less than 9x. Juice it up to 5% and you are less than 4x EV/EBITDA…Maybe I am just patriotic, but I am optimistic that in the long run, somehow, some way, american auto manufacturers will make money selling cars.

These are just a few of the nuggets that are starting to glisten in the duststorm of the markets out there. Tough to say that any of these have found a bottom yet, but at a certain price, even mud is worth buying if you think people will someday need bricks.

Enough optimism. There are sure clouds on the horizon. More on that later.

Thanks to ML for this photo that shows graphically what is obvious to anyone paying attention – we have had a “slight” bubble in the real estate markets over the last coupla years.

The font is too small to read so let me translate: greatest bubble in the past – scaled to 125%. Today – scaled to 200%.

Let’s just say I am not being paranoid (for once) when I say this will take a little while to come back to reality.