There was a house – a shack, really – that appraised for $132,000 and got a mortgage of $103,000. The owner hadn’t worked in 13 years. Upon foreclosure, a neighbor bought the house and paid $18,000 just to tear the thing down.

America, it seems, just went crazy – borrowers, lenders, nearly everybody. These anecdotes and others are told in a new book titled More Mortgage Meltdown by money managers Whitney Tilson and Glenn Tongue.

But what caused the mania and how we got there is less to the point than what happens from here. Even so, the stories are amazing…

“If the problems in the mortgage market were limited to subprime loans, then the carnage would be mostly behind us,” the authors note. Subprime loans were the riskiest mortgage loans. Prime loans. By contrast, were made to borrowers who made a substantial down payment and had good credit history.

The subprime borrowers were the fuirst to fail…but they certainly will not be the last. The nearby chart, which appeared in the May 22, 2009 edition of the Rude Awakening, shows the other mortgage markets, most of which are only now beginning to show signs of distrress.

The first thing to jump out at you is that subprime is only about a $1.5 trillion market – not anywhere near the biggest of the risky loan categories. There are other layers here.

Subprime is only one slice of low-grade bologna. It sits at the bottom. Alt-A is the next riskiest slice of mortgages above subprime. Alt-A are mortgages to people who are better credit risks than subprime, but still not prime. Documentation is still spotty as far as verifying income, and loan-to-value ratios are high. Plus, about a quarter of these mortgages went to non-owner-occupied homes – which were subject to even greater speculation.

The scary thing is that this mortgage market is 150% bigger than subprime. Unlike subprime, Alt-A loans typically have five-year resets – meaning, the interest rates adjust to higher rates. The Alt-A reset surge doesn’t really get started until 2010! It continues through 2012.

You’ll also see something called “option ARMs” on that chart. Even though the option Arm market is much smaller than the subprime market, it is also much riskier. An “option ARM” is a loan that allows the borrower to pay less than the total amount due from month to month. Whatever amount the borrower does not pay is added to the total loan amount…up to a pre-determined limit.

Obviously, loans like these are very easy to satisfy initially, but can become difficult or impossible if the borrower has been making token payments for a long time. What’s worse, these loans usually offered ultra-low teaser rates at inception, then re-set to higher fixed rates later on. The reset surge for these loans only starts in 2010.

You’ll also see something called “jumbo prime.” These are big loans – on average about $750,000. These were common in the most inflated bubble states, such as California and Florida, and were often made to poor credit risks. This is a market of $1-1.5 trillion – about as big as subprime.

Then there are home equity lines, which you’ll see just below jumbo prime. In calendar 2007, Tilson and Tongue explain, home equity lines funded “30% of new car purchases in California and 20% in Florida.” These loans are second loans, behind all the garbage I mentioned above. That means that many home equity loans will be a total loss for the lenders, as housing prices have collapsed and can’t even support the junk loans in first position, much less junior liens like home equity lines.

I won’t go into all of these loan categories, but I think you get the picture. All together, these “other” loan categories total more than $5 trillion – or more than three times sub-prime. Even worse, issuance peaked during the peak bubble years of 2005, 2006 and 2007.

Moreover, the pattern for all of these loans was the same. You see rapid growth in the bubble years, roughly from 2000-2007.

Through March of 2009, banks had taken only $1.1 trillion in write-downs to date. Even the most conservative estimates put total credit losses at $2.2 trillion. Tilson and Tongue make a convincing case that the losses will be far worse than that – more like $3.8 trillion. And these numbers seem only to grow over time. I remember sitting at a Grant’s conference over a year ago when John Paulson, the fund manager who saw all this coming and profited mightily, tossed out $1 trillion as the number for total losses. That number induced gasps at the time.

So I think Tilson and Tongue will be closer to the mark. It may well be even more than that when it is all said and done. The fallout from all of this is that the banks will have to raise a lot more capital. They’ve raised only $1 trillion so far – yes, “only.” Given the high leverage in the banking sector, they may yet need to raise at least another $1 trillion. I don’t see how that is possible in today’s market. Where is the money going to come from?

The margin for error is extremely small.

As banks’ assets got riskier – with subprime, Alt-A and all the rest – the banks actually borrowed more to hold these assets. The typical bank has only 4 cents of tangible equity for every dollar of assets. That means a 4% drop in asset value wipes out the equity – making the bank insolvent. The banking system is vastly undercapitalized. Throughout the 1990s, banks operated on leverage of about 16-to-1. Today, they operate on 25-to-one leverage…or higher!

And this, then, answers the great fundamental question that seems to baffle so many market commentators. Why aren’t the banks lending? People point to the trillions of dollars the government pumped into the economy, including on bank balance sheets.

The answer is that the bankers know they will need the money to cover losses from their toxic loan portfolios. The banks are clearly not lending. Banks are cutting lines of credit to consumers – and to businesses, too. New loans in various business categories are down 60-80% from where they were a year ago.

It is hard to imagine any economic recovery when the banking system has such gaping funding holes it needs to fill. As it is, banks are failing and the losses are severe – on average, the losses amount to more than 40% of assets. The data coming in on foreclosure recoveries are bleak. In California, recovery is often less than 35 cents on the dollar., which means a loss of 65 cents on the dollar. It’s not supposed to happen like this. If this crisis is anything like previous cycles, we’ve got a long way to go on bank failures.

How do we invest in this environment? For starters, continue to avoid banks and leveraged financial institutions in general. And don’t expect the banks to start lending so freely again anytime soon. That means you should also avoid businesses that depend on regular access to credit to grow – such as real estate investment trusts. I would also say that the housing market is not due for any recovery anytime soon. There is still enormous inventory to work through. So homebuilding stocks and related investments also face stiff head winds.

At the right price, I might buy almost anything else. But investing is hard enough without also taking on problems as big as the ones I’ve outlined here. There are plenty of other great places to fish. Continue to avoid the financials.

Source: The Ghost of Housing Past

On the other hand, when it comes to buying bonds, investors have one tremendous advantage: The corporations that issued the paper are legally required to pay the bondholders their interest and then return their capital – on time. It’s not optional.

Remember the movie, Goodfellas? There’s a scene where someone has borrowed money from the mob to expand his restaurant. He learns a painful lesson. The godfather gets paid, no matter what. As the movie explains in graphic language: “Economy goes bad? F*** you, pay me. Restaurant burns down? F*** you, pay me. Wife gets cancer? F*** you, pay me.”

When you’re a bondholder, the same rules apply. No matter what happens to the business or the stock price, you get paid.

The other good thing about the bond market is that most individual investors know nothing about it. As a result, there are tremendous inefficiencies, simply because most investors don’t buy individual bonds. Why not? They don’t know how.

Our newest product, True Income, makes individual bond recommendations, the way our other publications recommend stocks. But unlike stocks, the moment you buy a bond, you’ll know exactly how much money you’re going to make and when you’ll get paid.

Mike Williams, our analyst, is a 62-year-old CFA who’s been buying and selling bonds since before I was born. And he’s structured the product so subscribers will make big, triple-digit gains in fixed income – something most people believe is impossible. If you’d like to learn more about how Mike does it, click here.

Poor Henry Nicholas III, former CEO of Broadcom. He made the classic playboy mistake: He hired a personal assistant named “Kato.” Kenji Kato sued Mr. Nicholas last year for back wages and proceeded to spill his guts in his legal filings, which found their way to prosecutors pursuing him for backdating options.

According to Mr. Kato, Henry Nicholas was a one-man Tasmanian devil of bad behavior: He spiked the drinks of technology executives with Ecstasy without their knowledge, used thousands of dollars worth of illegal drugs while at work, and hired “prostitutes and escorts for himself and customers.”

Once, on a flight to Vegas on his private plane, Nicholas allegedly smoked so much pot, the pilot had to wear a gas mask! He must have been a fun boss, eh? Well, until the cocaine made him paranoid and violent. To keep the prostitutes quiet, Nicholas allegedly offered them money and threatened to kill them.

Our favorite commodities pundit, Jim Rogers, gave an interview to Bloomberg this week, and his story’s largely unchanged… Jim is still short all investment banks through an ETF. He’s specifically short Citibank and Fannie Mae.

Rogers also announced he purchased airlines. His reason… “Everybody’s very bearish.” He said flights are full, fares are increasing, and if you ordered a new plane today, you couldn’t get it for several years due to problems at manufacturers. Also, 24 airlines have declared bankruptcy and “bankruptcies are signs of bottoms, not signs of tops.”

In the last issue of my newsletter, PSIA, I compared the current real estate bust with the giant San Francisco earthquake of 1906. In that disaster, people set fire to their homes because they didn’t have earthquake insurance but they did have fire insurance. The resulting inferno destroyed 500 blocks – essentially the entire city. The earthquake didn’t cause most of the damage… the fires did.

The same thing is happening now in our mortgage markets. Home prices would probably stabilize. But the fraud and the crime that’s following the disaster is the real problem. No one will take responsibility for his actions. And that’s going to bankrupt just about everyone in the mortgage business.

SEC Chairman Christopher Cox thinks it’ll make everything all better if bond-rating agencies just put an “s” on the end of their ratings of structured finance products. One SEC commissioner objected to the plan, not because it’s just plain stupid, but because he said it was like putting a “scarlet letter” on those products. That’s roughly equivalent to worrying Britney Spears is getting too much negative press.

Regards,

S&A Research

The S&A Digest is written by Porter Stansberry, Dan Ferris, and Sean Goldsmith.

Source:  The Best of The S&A Digest  Saturday, June 14, 2008

That drop-off from the fourth quarter to the first quarter in the OFHEO’s “purchase-only index” exceeded the 1.4% decline between the third and fourth quarters of last year, and was the biggest decrease in the 17-year history of the index. On a year-over-year basis, home prices have fallen 3.1% since the first quarter of 2007.

All the figures were reported on a seasonally adjusted basis.

“For homeowners and financial market observers, these declines spell further erosion in home equity levels and potentially more trouble for mortgage markets,” James Lockhart, OFHEO’s director, said in a statement.

However, Lockhart also noted that the decline in prices could be good news for some.

“To prospective home buyers who have been shut out of homeownership because of affordability constraints, these declines may be welcome news,” he added.

The size of the first-quarter decline is yet another signal that the housing recession is still weighing heavily on the home market.

The steepest declines were in areas that experienced overbuilding, such as California and Nevada, where home prices dropped as much as 8% in the quarter, the OFHEO reported.

The drop in housing prices only serves to exacerbate the ongoing subprime crisis.

“It’s a dismal picture, there’s no way around it,” Paul Kasriel, chief economist at Northern Trust Corp. (NTRS) in Chicago, told Bloomberg News. “A complicating factor is the fact that so many homeowners owe more on their mortgages than their houses are worth. This is a financial crisis. You can’t put lipstick on this pig.”

As home prices drop, overextended owners are unable to sell for a price high enough to cover the outstanding balance on their mortgages. The result has been a large upswing in the number of home foreclosures.

Foreclosure filings have hit an all-time high, with a 65% year-over-year increase in April and a 4% increase from March, RealtyTrac reported earlier this month.

Almost two-thirds of U.S. banks have raised standards for mortgages, even to their most creditworthy borrowers, Bloomberg reported. For those with limited or bad credit history, so-called subprime borrowers, three-fourths of banks have raised lending requirements, according to a U.S. Federal Reserve survey of senior loan officers published May 5.

At the same time that consumers are finding it hard to obtain needed financing, the high level of housing inventory, currently at an 11-month supply, is making it very difficult for distressed homeowners to sell. The glut of homes currently on the market is putting downward pressure on home prices.

“The large overhang of real estate inventory awaiting sale continues to force price declines in many areas, but particularly in places that had seen very sharp appreciation in previous periods,” said Patrick Lawler, OFHEO chief economist.

Source: U.S. Housing Prices Suffer Worst Quarterly Decline on Record

The buck declined even more against the Canadian loonie, which appreciated better than 1% against its neighbor currency. Canada’s dollar is perceived as backed by more in the way of natural resources and therefore my be sounder than the U.S. version.

Some grim earnings reports helped deflate the buck. First, Fannie Mae reported a much wider-than-expected first-quarter loss of $2.2 billion, as credit-related problems hit it hard. The mortgage giant also said it needs to raise $6 billion in new capital.

Then, D. R. Horton, one of the nation’s largest home builders, reported a $1.3 billion quarterly loss as housing weakness and turmoil in mortgage markets continued to hammer its bottom line.

Additionally, Big Ben Bernanke made the news when in a speech he issued a warning that increasing home foreclosures could further harm the economy. Um, could?

Assessing the economic impact of foreclosures, Bernanke said that, “It is important to recognize that the costs of foreclosure may extend well beyond those borne directly by the borrower and the lender.” Wow, didn’t know that.

In its twice-yearly review of the global financial markets, the UN agency also warned that there is a “collective failure” to grasp the extent of leverage in the financial system that could further damage the health of the US economy.

According to a report on Reuters:

“The credit shock emanating from the US subprime crisis is set to broaden amid a significant economic slowdown,” Jaime Caruana, director of the IMF’s monetary and capital markets department, said at a news conference.

“The deterioration in credit has moved up and across the credit spectrum to prime residential and commercial mortgage markets, and to corporate credit markets. As the credit cycle turns, default rates are likely to rise across the board.”

“The horses are out of the barn,” says Gary North in The Daily Reckoning.

“The subprime real estate loans have been made. The slightly safer Alt-A loans have been made. The unqualified borrowers bought their homes at the top of the housing bubble: 2005, 2006. In 2007, the market visibly reversed. Now the delinquency rate has risen.

“The investment banks that loaned smart people all that stupid money are now hemorrhaging. They are lining up to get paid by busted hedge funds. When the courts and the lawyers get through with them, whatever is left over will have to be put on the books at market value, not book value.”

The extension of the ‘supervisory’ powers of the Fed to non-bank (deposit) financial houses like stock brokers), derivative dealers, insurance companies, and even to the private, high-risk investment companies of the rich, like hedge funds, is dramatic to say the least. But when it is realized that, in return for supervision, the Fed will stand behind those industries as a lender of last resort, the true revolutionary magnitude of today’s proposal becomes manifest.

Power grab

The new initiative was described persuasively as an attempt to ‘modernize’ our national financial monitoring systems and bring them in line to cope with the free-wheeling cowboy dealings that financed some $26 billion of bonuses paid to Wall Street firms alone in 2007! It all sounded so patriotically ‘good’ and deserving of massive popular support.

The truth is staggeringly different… so different that it commands a certain admiration for how the political/financial ‘pro’ Paulson was able to keep a straight face!

Reason to worry

The truth should alarm every hardworking American taxpayer who supports the improvement of our country and the handing of a working economy on to our descendants.

Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke, more than any two people on earth, were too well aware that two weeks ago, we faced a systemic collapse of our financial system that risked spreading to much of the developed world in short order.

Further, they knew that their emergency action to salvage Bear Stearns and other troubled brokerage houses would only postpone disaster, not prevent it. What was needed, to stand a chance of long-term survival, was a lender of last resort with massive resources.

When Hank Paulson soothingly mentioned “deleveraging”, he knew more than most that it meant some $12 trillion in the residential real estate market alone, excluding the excessive debt in the commercial real estate, auto loan and credit card markets!

Tax-payer insurance for Wall Street

The ‘real’ problem is far, far larger than the $800 billion balance sheet of the Fed can absorb! This fact alone should provide a salutary shock to investors who still hold U.S. dollar assets. It certainly did for our Treasury and Fed.

The Treasury and Fed realize that, over the past decade, they have pumped in so much money that has, in turn, become excessively leveraged, by banks and derivatives, that the government no longer has the funds available to avert a systemic financial disaster. That sort of mega-money could only be ‘captured’ directly from American citizens.

Behind Paulson’s responsible and pro-active sounding modernization plan is the most cynical plan to rob American citizens further, by making their government, through the Fed, the lender of last resort for Wall Street’s Billionaire speculators.

In the last resort, the Fed is financed by the Treasury, which, in turn, is financed by borrowing, taxing many Americans and robbing every single American through the debasement of their hard-earned dollars. Instead of allowing the free market to punish speculators, Paulson is now asking Congress to force the American citizen to stand as a lender of last resort, via the Fed, for the speculators on Wall Street, insurance companies, derivatives and, most amazingly, the most speculative of all rich investors – hedge funds!

The cynical arrogance of this ‘civic robbery’ is hard to accept.

The worst is yet to come

Make no mistake, the coming economic storm will be painful for us all. As if to rub salt into the wound, the hard-pressed citizen is now to be forced into bailing out Wall Street with injections not of billions, but of trillions in dollar liquidity.

To make it more politically acceptable, the Government must focus peoples’ attention on an attractive use of funds. Green, alternative energy would fit the bill handsomely. Indeed the President has already announced a massive increase in nuclear power generation as a first step.

Soon we should expect to see massive (trillions of dollars) government programs announced and the funding farmed out via the ‘needy’ on Wall Street.

In the meantime, direct financial aid will be administered via the Fed as lender of last resort.

In addition, we should expect accounting rules to be changed to allow the reality of ‘marking to market’ to be eradicated, allowing technically insolvent financial institutions to continue their vastly profitable operations.

The economic drag effect of the increased regulation is yet to be seen. But it is likely to prove insignificant when compared to the great latent damage done to the basic productive economy of America by hyperinflation.

What does all this add up to for the investor?

First, expect a continued erosion of the U.S. dollar as interest rates are lowered further to avert depression and as inflation subsequently morphs into hyperinflation.

Eventually, we should expect massive growth in the dollar earnings of green alternative energy companies as the confiscated largesse of the American citizen is pushed into that sector of the economy.

It remains to be seen whether Congress will authorize the required massive level of trillions of dollars in funding soon enough to avoid the present recession morphing into a depression.

Whatever the result, it is increasingly clear that the government intends to leave it for future generations to pay the ‘real’ bill for the reckless conduct of Wall Street and our Fed over the past decade.

In the meantime, investors keen to preserve their wealth should look abroad to the productive corporations and currencies of economies that continue to produce more than they consume