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Slow Grinding Wheels of Financial Fate
By Bill Bonner | Published  07/3/2007 | Stocks | Unrated
Slow Grinding Wheels of Financial Fate

Tomorrow, America's great middle class will celebrate in a great middle class way - with picnics, crab feasts, and outdoor barbecues.

The conversation is likely to turn to housing. But unlike the sunny July 4th holiday discussions of recent yesteryears, tomorrow's beery dialogues may be a bit overcast.

The United States is suffering the worst slump in the housing market since the '30s, say the news accounts. How bad is it, really? That's hard to say. The national statistics show a modest decline in prices - or even an increase, in some areas - with mounting inventories of unsold houses. In Las Vegas, the number of resold houses in May this year dropped by 28% from last year.

The wheels of Financial Fate may grind slowly...but they grind exceedingly fine. And America's middle class is beginning to notice.

"Home values and the $6 trillion U.S. mortgage-backed securities market are locked in a downward spiral," reports Bloomberg.

Bloomberg describes where the abstract - such as CDO pricing - hits the concrete - such as the cracked stone driveway.

"Bear Stearns is bailing out one money-losing hedge fund it controls and leaving another to liquidation by creditors. Both funds invested in securities backed by subprime loans. The loans, for borrowers with bad or limited credit histories, are secured by houses such as the one on Lilac Lane [in Decatur, GA].

"Bear Stearns took possession of the three-bedroom Lilac Lane house for $76,500 on March 6, according to the foreclosure deed. The owner who defaulted had purchased the house in April 2005 for $160,000 using a subprime loan that required no money down. He had been renting it out, according to the neighbor."

The local mortgage lender went bankrupt...the house was repossessed and sold for half the previous price. Then, rented out, its condition deteriorated. The paint flaked off. The concrete cracked. Possums moved in to the backyard.

And now, the proud owner is Bear Stearns (NYSE:BSC). The second biggest underwriter of mortgage-backed securities in the United States is rapidly becoming also a major owner of split-levels, neo-colonials, and Spanish-style bungalows.

Bloomberg adds:

"Bear Stearns and its affiliates are listed as buyers of at least 53 homes so far this year in San Diego County, California, 48 in Maricopa County, Arizona, and 40 in Cuyahoga County, Ohio, according to a search of property records.

"JPMorgan, the third-largest U.S. bank, and its subsidiary Chase Home Lending acquired at least 194 homes this year through foreclosure in Wayne County, Michigan. Merrill, the third-biggest securities firm by market value, and its mortgage unit, First Franklin, took possession of at least 87 homes this year in San Diego County, California. Citigroup and affiliates are the new owners of at least 47 homes in Clark County, Nevada.

"'Our expertise is in lending money to people to buy homes, it's not in owning homes,' said Chase Home Lending spokesman Thomas Kelly."

What's Bear Stearns going to do with the places? It can let Mr. Market do his work - putting the houses on the market and accepting whatever price he gives. But if it sells, it risks depressing prices of other homes in the area - many of which it owns! What's worse, "it will have a decimating effect on the mortgage-backed securities market when lenders start facing the music and letting property go at whatever price people will pay," says a local lender. But what did Bear Stearns expect? When its collateral goes down in price, so do the financial abstractions that rested upon them.

On the other hand, lenders can turn their backs to the music. But the music keeps playing. That is what the neighbors are likely to be talking about tomorrow: The possums...the cracks...and the predicament in which Bear Stearns finds itself. It can sell...or it can hold on, maintain, and try to rent. But whichever way it goes, woe awaits.

Faced with a similar situation in its sophisticated hedge funds, Bear Stearns decided not to let Mr. Market have his say...at least, not just yet. Rather than mark its portfolio of CDOs to market - by staging an auction of the assets in its troubled hedge funds - the company thought it best to keep things under tight control...putting off the day of reckoning, hoping that conditions in the CDO market might improve.

"What's really scary about this recent trend is that many mortgage-backed security portfolios are 'marked to model,' rather than 'marked to market,'" Strategic Investment's Dan Amoss told us today.

"This means that they're carried on the books at whatever the in-house math geeks think they're worth. There's no liquid secondary market for many of these securities, so this often serves as the only way to account for them."

Market conditions for collateralized debt obligations don't look so good. But neither do conditions for the collateral itself. Perhaps, Bear Stearns may be thinking, if it can just keep the possums out of the house on Lilac Lane, the place will be saleable, say, in a year or so, at a higher price.


"If this mortgage-backed security mess gets worse, there's a good chance that a 'ratings agency' scandal could unfold in the coming months - one that resembles the investment banking scandal of 2001-2002," Dan continued.

Then again, with so many people thinking the same thing, how likely is it that it will work out for them all?

"Steer clear of stocks like Moody's and McGraw-Hill," advised Dan, "they're exposed to the ratings business."

At this month's editorial meeting in Baltimore, Dan asserted that he sees this mortgage-backed security debacle as the next Enron...which could turn out badly for countless investors - but not for those listening to Dan's advice.

Like Jim Chanos, who made a fortune betting against Enron, Dan has a nose for finding holes in seemingly "healthy" companies - and now he's offering his readers a way to profit from a shoddy company's fallout. He is launching Strategic Short Alert, a new trading service that will focus on shorting stocks and buying put options.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.