Bill Fleckenstein

Contrarian Chronicles3/10/2008 12:01 AM ET

Next shoe to drop: Prime mortgages

The credit crunch is cutting a broad swath across the economy, and it's hard to know how far it will go. That's because for years, the housing bubble was the heart of the economy.

By Bill Fleckenstein

Several years ago, I sketched out a thesis called "The Next Time Down." Its onset took a bit longer than I had expected (like about three years) due to the lunacy in the credit markets. However, "the next time down" is essentially the situation in which we now find ourselves.

According to a friend I've dubbed the "Lord of the Dark Matter," credit is rapidly being withdrawn across a broad spectrum -- especially for the major brokers, giants like Goldman Sachs (GS, news, msgs) and Citigroup (C, news, msgs), which have served as enormous financial intermediaries. This is now raising the costs for nearly all credit-oriented hedge funds. And, my friend said, the pace of massive de-leveraging could accelerate further. That in all likelihood would feed on itself.

Lift a rock, find more schlock

I believe the next area of the credit sector to implode will likely be Alt-A -- loans granted to people who didn't want to document their income, also known as liar loans -- which will help illuminate the fact that our mortgage problems were never just subprime. Rather, they sprang from one big credit bubble, thanks to which mortgages were handed out to anyone who could fog a mirror. Most people took on more than they should have. (Some are now walking away from their obligations, a development recently highlighted in the media.)

In time, it will be clear that prime mortgages are also vulnerable.

"You can almost draw (the credit unwind) out in a diagram," said a managing director at the Economic Outlook Group in Princeton, N.J. "With home prices going down, consumers cut back on spending. If consumers cut back on spending, the economy weakens further. If the economy weakens further, fewer people are able to afford mortgages, so home foreclosures increase."

Meanwhile, the problems in the municipal market have been well-chronicled in the media. And, since the plain-vanilla money funds have already flirted with trouble, I wouldn't be shocked to see liquidity or credit issues in that arena, also.

Fannie Mae's new trick

Knowing the complete scope of this credit disaster is impossible because of the absurdly pliable accounting treatment accorded to financial institutions.

Case in point: Fannie Mae (FNM, news, msgs). Before excerpting one of the relevant passages from the company's latest quarterly financial report, let me cut to the chase with this explanation from a friend: "They take a delinquent mortgage loan and replace the delinquent part with an unsecured loan in order to circumvent the buybacks and mark-to-market consequences." That is the reality.

Here is how Fannie goes at lengths to sugarcoat it:

"We recently introduced a new HomeSaver Advance initiative, which is a loss mitigation tool that we began implementing in the first quarter of 2008. HomeSaver Advance provides qualified borrowers with an unsecured personal loan in an amount equal to all past due payments relating to their mortgage loan, allowing borrowers to cure their payment defaults under mortgage loans without requiring modification of their mortgage loans. By permitting qualified borrowers to cure their payment defaults without requiring that we purchase the loans from the MBS (mortgage-backed security) trusts in order to modify the loans, this loss mitigation tool may reduce the number of delinquent mortgage loans that we purchase from MBS trusts in the future and the fair value losses we record in connection with those purchases."

Obfuscation cannot change the big picture. The housing bubble -- which bailed out the equity bubble -- was in essence the economy. Now that we don't have the housing ATM or the jobs it created, the economy will continue to weaken.

Video on MSN Money

Jim Jubak
You haven't escaped the mortgage crisis yet
In a recent panel discussion on the US housing crisis, columnist Jim Jubak of MSN Money and Bruce Marks, the CEO of the Neighborhood Assistance Corporation of America, say there's still plenty to worry about.

It's pretty obvious that the Federal Reserve is in a box and that its decision to fight economic weakness by printing money has been a losing one. What the Fed fails to understand is that the best route to full employment is through stable prices and sound money. Its policies have trashed the dollar, created the explosion in the price of so many items and solved nothing.

Continued: Bullion as an antidote

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