Bill Fleckenstein

Contrarian Chronicles7/2/2007 12:01 AM ET

Finally, a voice of economic reason

When a respected financial guru such as Bill Gross says the subprime-mortgage crisis is going to spell trouble for other markets, maybe folks will start paying attention.

By Bill Fleckenstein

For several months now, many folks have claimed that mortgage problems were "only" subprime -- and/or contained.

Now, as the credit noose tightens at every level and facet of the mortgage business, it's pretty clear that anyone who made those claims had no understanding of what's gone on for the past several years or was not telling the truth. A reading of Bill Gross' monthly outlook for July, "Looking for Contagion in All the Wrong Places," should correct their views.

Home alone with the undeniable truth

Gross writes: "The problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks." Rather, "the real problem lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005 and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They're not going anywhere."

Gross goes on to note that people did not expect to end up in this predicament. They assumed that their teaser rates would be turned into new teaser rates.

What they really believed, though Gross doesn't mention this, is that house prices would go up forever. Folks were encouraged -- by Fed Chairman Ben Bernanke, former Chairman Alan Greenspan and virtually everyone else, save for a few of us skeptics who'd seen this movie before -- to think that everything was hunky-dory. Of course, all of the insanity that I have been describing on a regular basis is a function of irresponsible policies on the part of the Greenspan Federal Reserve and many other central banks.

As an important aside, I would just point to the acknowledgement -- in high places -- of that recklessness. In a recent report, the Bank for International Settlements (BIS) noted: "Behind each set of concerns lurks the common factor of highly accommodating financial conditions. Tail events affecting the global economy might at some point have much higher costs than is commonly supposed."

The aftertaste of the Greenspan era

That's from a June 25 story by Ambrose Evans-Pritchard of the London Telegraph, who writes: "In a thinly veiled rebuke to the U.S. Federal Reserve, the BIS said central banks were starting to doubt the wisdom of letting asset bubbles build up on the assumption that they could safely be 'cleaned up' afterwards -- which was more or less the strategy pursued by former Fed chief Alan Greenspan after the dotcom bust."

The consequences of that "strategy," as noted by Gross: "Escalating delinquencies of course ultimately lead to escalating defaults. Currently 7% of subprime loans are in default. The percentage will grow and grow like a weed in your backyard tomato patch" -- an indication that this problem is going to get worse and going to be with us for some time.

Gross goes on to note that if default rates climb to 10%, "even some single-A tranches face the grim reaper." (Editor's note: Those tranches were represented to buyers as high-quality debt instruments, supposedly among the safest pieces of collateralized debt obligations, or CDOs, that owned the risky mortgages in question.)

As for even higher-rated triple-A's, Gross says, "Folks, the point is that there are hundreds of billions of dollars of this toxic waste and whether or not they're in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind."

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He is not wondering whether this is going to be a problem, only at what rate it becomes a problem.

Easy money, difficult times

Gross warns: "The subprime crisis is not an isolated event and it won't be contained by a few days of headlines in The New York Times. And it will not remain confined to a neat little Petri dish in some mad financial derivative scientist's laboratory."

He goes on to say the U.S. economy will be affected, and "consumption will be reduced, to say nothing of new-home construction over the next 12-18 months."

Now, that is not news to regular readers of my column. But I share it because Gross is a person whom many people look up to. Avoiding the problems that have built up for years has been a function of denial, but the more you read about problems that you can see quite plainly, the harder it is to deny the very same. As someone who's widely read, Gross will help people believe that what their eyes are telling them.

As I've said many times, I don't know when the party in the stock market is going to end. But given all the leverage, and given all the trend-following, risk-seeking, quick-triggered, hot-money operators out there, I don't see any way that we can avoid a crash or crashlike experience. I cannot emphasize strongly enough that the leveraging up of America is over. But the de-leveraging and the problems associated with that have only just begun.

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