Bill Fleckenstein

Contrarian Chronicles7/16/2007 12:01 AM ET

Housing troubles begin to snowball

Credit downgrades by Moody's and possible downgrades by Standard & Poor's are a sign of serious trouble in the debt world that will eventually impact markets and the economy.

By Bill Fleckenstein

This week I'd like to describe approximately where I feel we are in the housing-ATM unwinding process.

That's not to imply that I think I know exactly what may happen next, but new clues have emerged since I wrote about the unwind a few weeks ago. They come to us via Standard & Poor's and Moody's, which last week announced potential or actual credit downgrades.

For readers who might not follow the bouncing ball of structured credit closely, let me explain why this is such a big deal.

Rejecting the hunky-dory story

To recap a long process: The housing market topped out in 2005, although until about six months ago, people continued to speculate in housing and use it as an ATM.

Those of us who felt we understood the speculation that had occurred believed quite strongly that once housing peaked, there would be real trouble for the economy and, by extension, the asset classes impacted by a housing bust.

The problems have taken a long time to play out, largely because of what we've recently come to discover but probably could or should have known all along: that the building blocks of the housing ATM -- more accurately referred to as structured credit -- were created in such a way that these securities were rarely marked to market. Rather, they were allowed to be marked to a model, based on a variety of assumptions. Essentially, therefore, one's assets were impaired only when the ratings companies downgraded them. (See my June 25 and July 2 columns for review.)

Rot bloomed in winter

Fast-forward to last February and March, which saw the implosion of a couple of dozen subprime lenders. Wall Street reacted by proclaiming the problem "contained." Though I essentially laughed at that sanguine response, now I understand what it meant: Those in the know understood that nothing was going to be marked to market, so the subprime-loan-originator implosion didn't matter.

Next, we saw the blowup of Bear Stearns' (BSC, news, msgs) High-Grade Structured Credit Strategies Enhanced Leverage Fund. That happened, in part, because manager Ralph Cioffi had tried to hedge some of its weaker credits with an ABX index that did get marked to market. Thus the fund lost money and was hit with redemptions.

Vested interests R us

At the time, I said that redemptions were going to force price discovery into the market -- although, as Jim Grant so eloquently put it in a recent issue of Grant's Interest Rate Observer -- Bear Stearns had a totally different opinion: "Price discovery could wait until the return of blue skies and normal pulse rates. The first order of business was price suppression."

This price suppression was the outcome folks had hoped for. After all, according to a July 11 article in Bloomberg, Wall Street took in about $27 billion in revenue from underwriting and trading asset-backed securities last year alone. It's a mighty profitable business that they are protecting.

Drumbeats in the junk-debt jungle

That no doubt seemed threatened July 10, when Standard & Poor's announced it had placed 612 bonds issued between the fourth quarters of 2005 and 2006 -- totaling $12 billion -- on credit watch with negative implications. Also, S&P said it was going to review the collateralized debt obligations backed by those bonds.

More importantly, it announced a change in the methodology used to rate existing and new mortgage bonds. Late that day, Moody's took a step further, saying it would actually lower the credit ratings on 399 bonds, totaling $5.2 billion, and put 32 other issues under negative credit watch for possible downgrades. Thus, the ratings companies, which have been complicit in this gargantuan misallocation of capital, now appear to be feeling the heat to "do something."

The combination of folks wanting their money back and the gradual return of the time-honored practice of mark-to-market -- aided by belated sobriety from the ratings companies -- will bring some acceleration to the spreading real-estate pain that has thus far been slow to develop.

(Although, given the long list of large retailers that are stumbling -- including Target (TGT, news, msgs), Sears Holding (SHLD, news, msgs) and J.C. Penney (JCP, news, msgs), as well as restaurant chains -- it's quite clear that the consumer is now feeling some pain.)

Wall Street and the hedge-fund community have been able to ignore all this, thanks to the mark-to-theory fantasy. I believe that chapter has ended and a new one is beginning -- that being the quaint old notion of price discovery. As I said, I don't know exactly how this will play out, but I think the process is finally going to speed up.