How housing ills killed the bull

By Bill Fleckenstein

The landscape of Wall Street has changed. Tuesday's shellacking leaves no other conclusion. But how has it been altered, readers will ask, and what might that mean? I've got my opinions, which I'd like to now share.

For the longest time, I have used a glib expression to describe the stock market as all one trade -- a giant Ponzi scheme, in some ways -- and said that when it ended, nearly all stocks would go down (as they have rallied so indiscriminately). Though that doesn't appear to be true on a day-to-day basis, when you take a step back, it really seems that way.

But I have also believed that, while for a long time seemingly nothing negative mattered, at some point literally anything might finally tip over the stock market. Whatever that might be, it would cause folks to sober up.

I think that process began Tuesday, and no shortage of folks ascribed it to the 9% drop in the Shanghai market hours earlier. I'm sure that had some impact, but I'm not convinced it was the cause, given that the headlines out of China (on authorities' intention to cool speculation) had been released earlier and hadn't stopped Shanghai from reaching a new high the day before.

When the little hand's on the 3

Likewise, let me dispute the notion that malfunctioning electronics were the cause of the market's decline. For a variety of reasons, folks have been lulled into a sense of complacency, made apparent by a whole host of measures. When they all decided to hit the "sell" button at once, the market couldn't take it. As for why it happened around 3 p.m. ET, an astute friend cited that as the time when mutual-fund redemptions are known. Thus, the news that they were sizable precipitated the sell orders and all the damage.

Now for what I think finally mattered to the stock market last Tuesday, although it's been hiding in plain sight: the unraveling of the subprime-mortgage market. (Or, as I headlined my daily column that day, "Gaps Galore: Think Credit, Not China.")

In fact, it was only the night before that I e-mailed a knowledgeable friend (whom I have been quoting in this column since November), seeking to confirm stories I'd heard that big brokers and financial institutions were pulling their warehouse lines, the credit lines the brokers extend to subprime lenders. (That's a measure of how seriously they were taking the threat of potential losses in the subprime arena.) His response to my query prompted me to think that we might finally be in for a little "contagion" Tuesday. This is what he wrote:

For Merrill Lynch, no cheer

"Things are so bad now, it almost seems like it cannot get worse. Goldman Sachs (GS, news, msgs) says book value of FF (First Franklin, which Merrill Lynch (MER, news, msgs) purchased four months ago for $1.3 billion) is now worth $300 million at best. Goldman and several others have pulled out of second (mortgage) market completely. Watch for second rates to explode and thus price many out of business. I have no idea what happens next. If things went in orderly fashion, we should implode now. If the market stayed like this, the ripple effects through real estate market would be enormous. The dominos are ready to fall. Goldman says five months before things stabilize."

Furthermore, my friend in the financial-dark-matter world alerted me to the fact that the ratings agencies seemed to have figured out that some of their models may be too skewed to the upside. (Apparently, what they've built into their models is a housing appreciation on the order of 4% to 5%.) According to his sources, that may be under review, which could precipitate some downgrades of mortgage CDOs (collateralized debt obligations). At this juncture, anything that causes disturbances in the dark-matter universe will have a mighty impact.

Which obviously makes sense, in the ATM economy that I have described ad nauseam over the last few years. To repeat myself: The whole economy will be impacted when the ATM machine and its financing mechanisms begin to stumble.

An elusive but ineluctable outcome

Finally, I would like to address the complaint of some folks: that although I've talked about the "next time down" scenario since the housing bubble became one, it hasn't yet occurred. Except for a handful of occasions when I thought it might be starting, I didn't mean to imply that it was going to occur at any moment. What I meant is: Once the process starts, that's what it will turn into.

Exactly when that was going to start has been elusive, but I now think we are quite close. It could easily be under way by spring, when even more people put their houses up for sale and find that they don't sell because buyers can't get financing. I cannot emphasize strongly enough what the change in the bowels of the ATM-financing mechanism means to the economy. There is just no quick fix to the unwinding of that credit bubble.

At the time of publication, Bill Fleckenstein did not own or control shares of companies mentioned in this column.