Monday Mop-Up

Well that all seemed very nice today didn't it?

I was happy we beat (other than the Dow and Transports) all of our 33% goals until I realized where we stopped.  In the Dead Cat Bounce Weekly Wrap-Up I mentioned that a proper Fibonacci retracement was 38.2% and our 33% goals were just a way station towards a proper retracement.

All day today I was fairly frozen as I saw positive market action but I just couldn't bring myself to jump on it so I neither bought nor sold.  Oil went down below $59 but the Transports were flat, the S&P was unimpressive even through the oil stocks rallied (don't ask me why), the miners also bounced back even though gold laid flat and the Russell and NYSE were just so-so, with .5 and .3 gains.

Just so you know, here's what a proper recovery looks like:

Where we are now (assuming we are recovering) is most likely in the first leg of a recovery after a drop, likely to retest our lows at least once before we can really turn things around.  Here is the current S&P chart:  Does THIS PATTERN look familiar now?

It's all up to Goldman in the morning, TXN already gave disappointing (but really fine) guidance this evening, which will let some air out of the SOX and it will be truly amazing for GS to overcome the sub-prime fears that are starting to dominate the conversations among traders.  Bloomberg just put out a devastating article claiming:  "1.5 million MORE Americans may lose their homes, ANOTHER 100,000 people in housing-related industries could be fired, and an estimated 100 ADDITIONAL (34 so far) subprime mortgage companies that lend money to people with bad or limited credit may go under, according to realtors, economists, analysts and a Federal Reserve governor. Financial stocks also could extend their declines over mortgage default worries."

"The spring buying season, when more than half of all U.S. home sales are made, has been so disappointing that the National Association of Home Builders in Washington now expects purchases to fall for the sixth consecutive quarter after it predicted a gain just last month.  The correction will last another year,'' said Mark Zandi, chief economist for Moody's Economy.com in West Chester, Pennsylvania. “Fewer people qualifying for mortgages means there will be less borrowers, and that will weigh on demand.''

There are 10M families living in homes with sub-prime loans and 2.2M of them are considered "at risk."  Since many of these loans are adjustable loans and since the lending requirements are tightening up the net effect is that these people are becoming trapped in the loans they have (they don't qualify for a refi anymore) and all 10M will be crushed if mortgage rates tick up.  Starting to sound less than optimal isn't it?

While a borrower who took an adjustable 3% loan on a 250K mortgage may have expected his payments to go up from the "teaser rate" of $1,054 per month to a 6% rate of $1,498 per month (assuming the very honest mortgage broker properly explained the risks), it is unlikely they considered having to pay an 8% interest rate, which would run monthly payments all the way up to $1, 834 per month.  You can see how quickly this becomes a problem.

Already I am seeing the typical spin-doctoring Emails going around with jokes and "examples" of how the people in these homes are some sort of scam artists who deserve to get kicked out.  Expect to be inundated with these stories by the media as the VERY powerful Mortgage Bankers Association expends some of their $4T in annual revenues to convince you that they are the injured party here – not those evil little families who pretend they can't handle a lousy $800 a month increase in their mortgage payments.

If they couldn't afford a loan, they shouldn't have put their life savings into a home should they?  After all, they SIGNED THE CONTRACT, which clearly stated the bank could not guarantee that the 3% interest rate would continue after the first 5 years so they TRICKED the poor bank and whooped it up in their low-cost home and now they have to be kicked out (and sued under the new bankruptcy laws which Congress cleverly changed 2 years ago after a huge lender lobbying effort).

You'll notice COF has pulled back their clever ad campaign as the sub-prime mess has put them in the very same position regarding retail clients that they accuse "big banks" of being in with business clients.

So we'll see what the spin is from Goldman and the other brokers this week as they are knee-deep in this sub-prime mess but they are so large, with so many interests, that they can actually sweep a few billion under the rug for a quarter or two and I doubt Paulson would be too thrilled about his old pals at GS making statements that put a nail in the coffin of the US Housing Market.

Here's a nice WSJ graphic that shows the interconnection between the Mortgage Lender, the Commercial Bank/Wall Street Firm, the Bond Market and the Credit Default Swaps.  MS, for example, is owed $2.5Bn by NEW alone – so much money that they just gave new an additional $265M to cover part of the $717M that New Century owed to Citigroup over a  "margin deficit."   Citigroup was smart enough to be first to file a default against NEW.  On Thursday BAC and IXIS also filed but I think Morgan Stanley may be running out of money to prop up this mess.

Robert Napoli at Piper Jaffray said assuming a 20% loss rate on loans it is forced to buy back from its creditors, New Century "would have to absorb $1.6 billion of losses, essentially wiping out shareholders equity." As of Sept. 30, the company listed $25 billion in assets, about $23 billion in liabilities and $2 billion in shareholders' equity.

So forgive me for having a hard time jumping on the bandwagon.  I know I promised to be more bullish but this is a big problem folks – really, really, really big and it's not going to go away just because the brokers have "repurchase agreements" which obligate the mortgage originator to buy back problem loans.  HSBC is running around the country hauling every origination lender who defaults into court to collect on that agreement but how long before that plan falls apart?  How much will be left for commercial brokers number 2, 3, 4 and 5?

Is this an isolated incident?

We'll see tomorrow.  I was shocked and amazed at the recovery by the major brokers ahead of GS earnings and I do stand ready to go gung-ho bullish if they can convince me that sub-prime lending is not going to spread and suck all the free cash flow out of the financial markets but I also remain sensibly prepared to have my worst fears confirmed so I'll be watching our danger levels as much as the new breakouts I'll be setting in the morning.