Even if the Fed pauses, the trend is down

By Bill Fleckenstein

For the last week or so, I've vacillated between which of my two opposing views was right. Here is how I described the first one, in my daily column of July 19:

"I have been reducing my short exposure in the last couple days, due to my fears of a combined Fed-is-done and no-news-period rally. The fact that so many people have been terrified by the only thing they should not fear, i.e., the Fed, made me very uncomfortable being short."

Then, I changed my mind a few days later, thinking that the tape was so weak that my former view wasn't going to matter. To quote last week's Contrarian: "In my opinion, the recent action suggests an inflection point, whereby economic weakness and disappointments are getting the upper hand."

Of course, when the tape recently toasted a weaker-than-expected GDP report -- ignoring the implications of what a slowing economy means for corporate earnings -- I was kicking myself, thinking I was right in the first place.

Vacillation aside, I believe that whatever rally the market may have left in it will be expended shortly after the Federal Open Market Committee (FOMC) meeting on Tuesday. That assumes (as I do) that the Fed will give us a "nothing done," i.e., a pause -- leaving the federal funds rate at 5.25%.

If stocks start down in the wake of that and if we begin to get more economic disappointment, you can imagine that it might disturb the bulls quite a bit, especially if they ever stop to consider some of our macroeconomic (as well as geopolitical) problems.

Will love of condo go way of dodo?

One such problem -- the rot that lies ahead for the "structured-finance" wing of the housing food chain -- was the subject of "Condo Woes," a story in last Tuesday's Wall Street Journal (subscription required). Said the story: "In the latest sign that supply of condominiums has outstripped demand, a leading national developer of condo-hotels has missed payments on loans for two major projects."

According to a Standard & Poor's report on the health of the commercial mortgage-backed securities market, the story noted, "delinquencies continue to drop, although pockets of weakness exist." The report noted that two commercial mortgages securitized by Credit Suisse (for a Chicago developer) "have caused some concerns."

I have not spent much time talking about collateralized mortgage obligations, collateralized debt obligations or credit default swaps, as they are incredibly complicated. (However, the recent weakness in financial-related stocks -- like Countrywide Financial (CFC, news, msgs), Triad Guaranty (TGIC, news, msgs), AmeriCredit (ACF, news, msgs), MGIC Investment (MTG, news, msgs), Fannie Mae (FNM, news, msgs), Downey Financial (DSL, news, msgs) and New Century Financial (NEW, news, msgs) -- is plain as day.)

To spend a minute on New Century in particular, the company reported a slight miss when it reported earnings last week. But what is really important: The fact that loans it held for sale ballooned sequentially from $6.3 billion to $9.3 billion. (Of course, that's on top of the $16 billion or so that New Century holds away from that particular category.) Nevertheless, the company chose not to bump up its loan-loss reserves.

Further questionable developments: "Other income" was up radically year-over-year, and no one seems to have a good handle on exactly what's in that category. More ominously, FPDs (first-payment defaults) were up considerably. A very knowledgeable friend who's an insider in the sub prime industry said: "That is the single-worst thing you can see in a company -- people who never make the first payment. I cannot begin to tell you how bad things are, and getting worse."

Even the people who are supposed to understand these complicated products probably don't. Jim Grant, in his last couple of issues (subscription required), has attempted to delve into these markets, and folks should read him to learn more. Suffice to say, as the real-estate market unwinds, we will see enormous problems cropping up in the whole arena of structured finance and the derivatives that go with it.

I'm sure many financial institutions will be impacted negatively by these developments, but so too will many hedge funds. According to the Journal story: BlackRock affiliate Carbon Capital II was the mezzanine lender to the Chicago developer who missed his payments. The hedge fund made the payments and could take over the developer's property (though I'm not sure that was the fund's goal when it made the loan).

The toxic detritus of bad debt

This is the first I've heard of missed payments by a developer -- though I imagine that others have occurred. I expect to see many more still. However, I have heard about isolated cases of "jingle mail," where homeowners have mailed in the keys because they can't make the payments and no longer have any equity in their homes.

That phrase was a prominent feature of the S&L bust and ensuing real-estate debacle in 1990-1991 -- and something we'll be hearing lots more about in the future. As sure as I am that there's going to be a train wreck in structured finance/derivatives, I'm sure I only have the faintest idea of how bad it's really going to be.

Now to wrap up on a positive note, or make that two. My favorite silver-mining company, Pan American Silver (PAAS, news, msgs) -- whose assets are dug up from the ground, rather than synthetically created by questionable debt -- had a pretty good quarter. I say that as a biased observer, shareholder and company director, though there's radically too much emphasis on quarter-to-quarter developments, in my opinion.

And, turning to a case where quarterly results really don't matter, Nastech (NSTK, news, msgs)held its update last week. I think the important thing to note is that not only did the company not burn cash, but its cash is increasing. Which is an extremely important factoid for folks to focus on when considering a young biotech or bio-delivery company. Also, it's impressive to see the various products that Nastech has either in the clinic (clinical trials) or about to go into the clinic.

For anyone who didn't listen to the company's quarterly call last week, I suggest checking out a couple of fine synopses on the message board at investorvillage.com. (All of the knowledgeable posters have left Yahoo! (YHOO, news, msgs), as have I.) In any case, I continue to believe that Nastech is an incredibly exciting story. I just wish we weren't entering a bear market, because even though I have a chunky position, it would be a whole lot chunkier if that were not the case.

Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckenstein Capital Web site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. At the time of publication, Bill Fleckenstein was long Pan American Silver and Nastech. He was short or had long puts on Countrywide Financial, Triad Guaranty, AmeriCredit, MGIC Investment, Fannie Mae, Downey Financial and New Century Financial.