S&P’s said the “outlooks on the large financial institutions sector in the U.S. are now predominantly negative” and that “the pace and extent of earnings improvement could be considerably more muted than we previously anticipated.”

“Lehman Brothers, the most vulnerable of the three houses downgraded, got it the worst,” say Ian Mattias and Addison Wiggan in the 5 Min Forecast. “Traders pushed LEH down 8% during yesterday’s session.”

This morning, the suits at Lehman are putting together a plan to raise more emergency capital. Having already raised $6 billion over the past year, Lehman is far and away the most likely candidate to play the role of “next Bear Stearns” during this encore production of the credit crisis.

“What does Wall Street expect?” asks Dan Denning in The Daily Reckoning Australia. “We’re in a bear market in credit.”

The grim news Stateside is that the board of directors of Wachovia, the fourth largest bank in America, fired its CEO Ken Thompson. Wachovia lost US$708 million in the first quarter of 2008. It didn’t help Thompson that he engineered the acquisition of mortgage lender Golden West Financial in 2006 – right at the peak of the mortgage lending bubble.

Thompson joins a long list of CEOs falling on their sword for thinking a credit boom would never end. It has. It’s still ending, in fact. Ratings agency Standard and Poor’s lowered the credit ratings of three big Wall Street firms earlier today. JP Morgan, Lehman Brothers, and Merrill Lynch were all downgraded because the S&P reckons the firms will have to take further asset write downs this year.

What did you expect? It’s a bear market in credit. The story comes straight from the department of news so obvious a rock would know it. What does it mean?

Well, a bear market in credit is bad for firms with heavily leveraged balance sheets. That includes most financial and banking stocks. Why any investor would go bottom fishing in the financials when we still have a bear market in credit is beyond our reckoning capabilities.

William Patalon III in Money Morning reckons investors should take the fresh warnings about the credit crisis from Oppenheimer & Co’s analyst Meredith Whitney to heart.

Whitney now says the worst may be yet to come. The banking-sector financial crisis will last at least until the end of next year, and may actually stretch well past that. And that could lead to a major U.S. downturn.

“We believe the credit crisis is far from over,” Whitney wrote in a research report last week. “In fact, we believe what lies ahead will be worse than what is behind us.”

The so-called “first wave” of the credit crisis hit banks’ trading books. But the second lightning strike will hit lenders where it hurts the most – right in their lending businesses. If she’s right, the impact on the economy will be devastating.

Here’s why. The banking system’s “originate-to-distribute” model changed the rules of the game. No longer did banks make loans that were based on very careful risk-of-loss analyses. Under the new system, banks make loans – such as subprime mortgages – which are then “securitized,” or packaged together, into debt instruments that the trading operations of banks, investment banks or institutional investors might then purchase, believing it was a way of achieving higher returns.

Initially, this led to higher profits. Which induced banks to boost lending so that they could boost securitizations. But here’s the problem. First, since the banks were no longer going to keep the loans, they relaxed lending standards. In fact, they actually had to since, second, they wanted to boost those volumes.

When the underlying loans unraveled as the subprime-mortgage crisis spiraled deeper and deeper out of control, companies such as The Bear Stearns Cos. Inc. (BSC) took losses that just kept growing. Bear Stearns is now being taken over by JPMorgan Chase & Co. (JPM), with the help of the U.S. Federal Reserve.

The sins weren’t limited to banks, however. Consumers stoked this credit inferno – and, in doing so, unknowingly created their own funeral pyre.

Consumers grew accustomed to the “rolling loan gathers no loss” mindset, Whitney says. Housing values were soaring, and as long as those values continued to rise, homeowners could continue to roll over their loans into new borrowings – often packing in a lot of ancillary consumer debt from credit cards or car payments long the way.

When the housing market collapsed, however, homes were no longer a real-estate-version of an automated teller machine (ATM) that consumers could turn to each time they needed to eradicate debt from car loans, home loans or even credit-card debt.

When banks stopped lending, consumers had nowhere to turn to roll over their loans. Making matters worse were two other factors:

• First, many of their loans had so-called “re-set” provisions that permitted the loans to reset at much higher interest rates – a fact that caused the overall monthly mortgage payments to increase, sometimes by as much as 40% or more. And since their incomes weren’t rising in kind, many consumers could no longer make these payments, and defaulted on their mortgages.
• Second, the downturn in the housing market sent home prices into a severe tailspin, in some cases leaving homeowners with mortgage balances that were much larger than the new (lower) market value of their home. And if the mortgage loan also reset, that homeowner was hit with a double-whammy blow – a boosted mortgage payment on a house whose value had plunged.

Those resets have caused foreclosures to soar, the news is going to get lots worse, real estate data firm RealtyTrac Inc. said last month. Indeed, U.S. home foreclosures likely won’t peak until the fourth quarter, Money Morning reported last month.

“What we’re really looking at is ongoing fallout from people overextending themselves to buy homes they couldn’t affordand using highly toxic loan products to get into the houses in the first place,” Rick Sharga, RealtyTrac’s vice president of marketing, told The Associated Press. “We’re going to see quite possibly a record amount of foreclosure activity in the third or fourth quarter,” reflecting the spike in monthly payments because of the re-sets on adjustable-rate subprime mortgages that will take place in May and June.

And that brings us back to Whitney.

The banking sector’s lending pullback will fuel these losses and foreclosures, for many of the reasons we’ve detailed here. Already, banks will likely have to set aside an additional $170 billion in reserves through the end of 2008 – just to keep up with mounting loan losses.

To do that, banks will have to further rein in lending – to the tune of about $2 trillion worth of available credit lines, BusinessWeek.com reported. For some context, the annual gross domestic product (GDP) of the entire U.S. economy is approaching $14 trillion. Two-thirds of that is driven by consumer spending.

That’s why the lending pullback is going to have a massive contractionary effect on the U.S. economy.

“New and unforeseen strains on consumer liquidity will push more consumers into precarious credit positions and cause consumer credit losses to be far worse than what is currently estimated, even by the most-draconian of investors,” Whitney wrote.

Economists expect the gross domestic product to be revised up to 0.9% in the first quarter, from the initial estimate of 0.6% when the government releases the data on Thursday morning.

However, many economists aren’t so sure that the ailing US economy is out of the woods yet. They argue that the toughest times may even come next year until the impact of the economic stimulus wears off.

“The cold shower will come when they realize [the pop] from the stimulus was just temporary and there are a lot of big fundamental problems and growth is just going to fade away in the fourth quarter and first quarter of next year,” says Nigel Gault, chief US economist at Global Insight, quoted in the report.

“The economy needs more than a jump start to get it going. The engine has too many problems to kick into gear until the middle of next year at the earliest.

William Patalon III says the bearish case for the US economy is strong and has just got stronger following a prediction of a major lending pullback by Oppenheimer & Co analyst Meredith Whitney.

“Whitney’s reputation has soared like a skyrocket since she made her bearish — but highly prescient — call on the banking sector, including Citigroup.

“Now she’s back. And her outlook for the financial sector is actually worse. Whitney is now predicting that the banking-sector’s financial crisis will extend well into next year. If not beyond.

And that’s not even the bad news.

Whitney now says the worst may be yet to come. The banking-sector financial crisis will last at least until the end of next year, and may actually stretch well past that. And that could lead to a major U.S. downturn.

“’We believe the credit crisis is far from over,’ Whitney wrote in a research report last week. ‘In fact, we believe what lies ahead will be worse than what is behind us.’

The so-called ‘first wave’ of the credit crisis hit banks’ trading books. But the second lightning strike will hit lenders where it hurts the most — right in their lending businesses. If she’s right, the impact on the economy will be devastating.”

Whether it was frantic buying or frantic short covering is unknown. But once the 20-day moving averages for both metals were significantly challenged, someone decided that that was enough…and both metals started down the moment that London closed for the day. Volume was pretty decent in both metals.

Wednesday’s open interest numbers are as follows. Gold o.i. rose 1,594 contracts and…once again…silver did the opposite, with o.i. down 670 contracts. This won’t be in the COT until May 23rd.

I’ve talked a fair amount about the 20- and 50-day moving averages the last week or so. Sooner or later, they will be broken to the upside by a substantial amount, and the tech funds will come pouring back in…and away we will go again. But before you start cheering, you need to keep the following in mind. The price of both gold and silver have always been a dance between the tech funds in the Non-Commercial category and the bullion banks in the Commercial category…always. At this moment, near the lows in price (and the 200-day moving averages), these same bullion banks are still short (as of the last COT) a knee-wobbling 79% of the entire Comex gold and silver market…not just the Commercial category where they reside. As these previously mentioned tech funds go long…who is going to take the short side of their long transaction? If it isn’t going to be the bullion banks, it certainly isn’t going to be anyone else, as all but 21% of the rest of the traders are LONG gold and silver. What happens then will determine whether prices explode to the upside (because no one wants to take on any more short positions), or the bullion banks go even shorter…and more concentrated. That time is getting very close.

I see a couple of days ago that banking analyst Meredith Whitney blasted Citigroup’s turnaround plan saying the financial giant “is so deep in a black hole that even renowned physicist Stephen Hawking could not help the ailing company.” Not too many shades of grey in that comment.

And in the King Report last night, there was this Freddie Mac answer to an analyst’s question…”No it’s not, Paul. We made a determination in the first quarter that given how widely the pricing we were getting on the ABS (Asset Backed Security) portfolio, that it no longer made sense to leave that in Level 2, so we essentially moved the entire ABS portfolio into Level 3. We were still using the mean pricing that we were getting from the dealers. So we’re not using a model price.” Freddie Mac now has an eye-watering Level 3 (mark to myth) portfolio of $157 billion. Everything is fine.

Two stories today. The first is from chief investment strategist John Embry over at Sprott Asset Management in Toronto. It’s his latest commentary posted in Investor’s Digest of Canada and is entitled “Last Chance to Board Gold Train at under US$1,000″. The pdf file is linked here.

The second article is from Ambrose Evans-Pritchard from the The Telegraph in London. It is more than worth the read because there is clear evidence of serious conflict boiling up inside the EU, and there is quite a discussion about it. The article is entitled “OECD Warning as Stagflation Goes Global” and is linked here.

Between two evils, I always pick the one I never tried before. – Mae West

The President’s Working Group on Financial Markets must be in a frenzy about now. How they keep the markets levitated in the face of total economic disintegration is beyond me. Today’s activity will probably be another circus…Fridays always are…and we at Casey’s Daily Resource Plus will be here to report on it on Saturday. Have a great weekend.

Casey Research correspondent-at-large Ed Steer is a keen observer of the financial scene and a board member of GATA.org.

Source: And Then There’s this…Friday, May 16th, 2008