Bill Fleckenstein

Contrarian Chronicles2/26/2007 12:00 AM ET

Subprime housing game is over

What's remarkable is that Wall Street was surprised by the implosions of lenders NovaStar Financial and New Century Financial. What we don't know is how quickly this mess will impact the economy.

By Bill Fleckenstein

Why does the stock market at large seem not to care about the many problems that exist? My best explanation is this: The stock market, which is normally thought of as a discounting mechanism, doesn't work that way at the moment.

For the better part of at least six months, and perhaps nine, it has traded more like a price-discovery market (think voting machine). That's how commodities such as wheat and corn trade -- they just get pushed from one price to another. Daily reactions are almost totally to price, although fundamentals are loosely correlated.

Everyone has grown up thinking that the stock market discounts, meaning it anticipates a company's operational performance and prices a stock accordingly. The market has done so in the past, and it will again.

But for now, it discounts next to nothing. Witness the huge gaps seen recently in the subprime sector, where problems seem to have arisen out of the blue -- although they have been easily foreseeable, as I have been chronicling in this column. When the market reverts to discounting and ceases to be the price-discovery animal it is today, there will be a tremendous amount of violence on the downside.

But let's wind the tape back to Wednesday, when a sizable blow dealt to subprime lender NovaStar Financial (NFI, news, msgs) -- which followed the previous week's similar implosion at New Century Financial (NEW, news, msgs) -- mattered only to that sector. NFI effectively bit the dust, announcing that it wouldn't produce any net income through 2011. The news from NovaStar should not have come as a shock to regular readers. After all, how viable is a business that's built on lending money to people who can't pay it back (unless the assets behind the loan rise in value)?

The gullibility is the shocking part

Yet NovaStar's implosion caught the "professionals" -- i.e., Wall Street, the holders of NFI subprime paper and the dead-fish community at large -- by surprise. Consider this headline from a report on NovaStar by Stifel, Nicolaus: POOR 4Q 06; UNFATHOMABLE (AND INEXCUSABLE) DIVIDEND GUIDANCE.

A Stifel, Nicolaus dead fish who follows NovaStar whined that its "limited disclosure renders forecasting taxable income nearly impossible (by management's own admission), so we perhaps shouldn't be so surprised. Still, we firmly believe that management should have better communicated this impending change."

Here is a (presumably highly paid) certified financial analyst who recognizes that NovaStar's business is hard to forecast, and he ought to know that its accounting is extremely flexible. Yet he is shocked and blames management for his gullibility. I bring this up not to pick on the individual in question but to point out what's happening throughout Wall Street, in all different industries.

Ignorance aside, it pays to state the obvious: The subprime industry was absolutely critical to the inflating of the real-estate bubble. If loans had been made only on a responsible basis -- to people who put money down and looked like they could actually repay the money, irrespective of rising house prices -- that bubble would never have achieved anything close to the heights it did.

That game is obviously over. Let me repeat that -- over. The real-estate market of the past few years will not be seen again in our lifetimes. The only thing we don't know is at what rate this unwinding will play out across the economy and, more importantly (to me), in the minds of the Goldilocks-enthralled community on Wall Street.

Would you woo WaMu?

To illustrate the current state of complacency, Washington Mutual's (WM, news, msgs) stock price is just a couple of dollars away from its all-time high. I mention WM because although it's a large financial institution deemed to be soundly managed, I believe that it has an inordinate amount of exposure to subprime loans -- and therefore is an accident in waiting. What holds the stock up is the belief that JPMorgan Chase (JPM, news, msgs) will take over the company, which is one reason why I've been afraid to short WM. (Yes, JPM, in my opinion, would be crazy enough to buy it.)

In the dark-matter universe (for a quick primer, click here), risky BBB tranches (subgroups) of home-loan-backed securities have been annihilated, and now the A tranches are weakening. Supposedly, the real pain will start when the higher-rated AA and AAA tranches start to weaken. But really, one won't need access to dark-matter market quotes to know that trouble is at hand. It will be obvious when stocks like Washington Mutual and other housing-finance-related stocks start sinking.

Getting squeamish over subprime

Meantime, the big question remains: When will folks be forced to connect the dots? Unknowable though the answer may be, my friend in London provided a clue, via a recent e-mail:

"You and I and a select group of others have been all over subprime for months now. But today (last Wednesday) is the first day where equity managers have been in to us, asking questions about subprime. Until today, most of the equity managers knew something bad was happening in subprime, but were prepared to assume it was not going to be a problem for the wider credit market, the economy, and so on. . . .

"Slowly but surely, people are starting to get it, and slowly but surely, I am starting to think that the tipping point in credit -- via a subprime-generated shambles in CDO (collateralized debt obligation) land -- is closer than anybody imagines."

Video on MSN Money

© Corbis
Video: Housing Hurts
CNBC real estate reporter Diana Olick reports that housing starts are at a 10-year low.

Behind the scenes in the land of financial black boxes, the time bomb is ticking.

A singer of subprime's praises

Lastly, I would like to share a quote from Easy Al, taken from a speech dated April 8, 2005 (not so very far from the zenith of the real-estate market). I don't talk much about Al Greenspan anymore, mostly because he's gone from the scene, and I spilled so much ink on him before he left. But if you had to pick one man responsible for the imbalances in America and the financial hangover coming our way, it would be Al, who said:

"Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. . . . With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers. . . . Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending . . . fostering constructive innovation that is both responsive to market demand and beneficial to consumers."

I would imagine that if consumers who took Al's advice could, they would be lining up to sue him for malpractice. There's one class-action suit I'd be happy to join.

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

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