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

– The broader Standard & Poor’s 500 index did even worse. The S&P 500 was the worst performer among the major indexes. It shed a whopping 6.1% and hit its lowest level since April 2003. The fear and loathing on the Street is palpable.

– Today, U.S. stock futures slipped thanks to what normally chirpy MarketWatch calls “the brutal economy that companies are navigating.” S&P 500 futures edged 2 points lower to 900.80 and Nasdaq 100 futures fell 7.25 points to 1,240.70. Dow industrial futures rose 5 points.

– Agora Financial’s Chris Mayer, one of the smartest contrarian investors we know, is quoted on Addison Wiggan’s 5 Min. Forecast blog as saying: “What we are going through now is a history-making crash. There is a reason it caught so many people by surprise — it hasn’t happened before, not quite in this way.”

– Addison also quotes Bill Bonner. Bill has been calling this crash for years in The Daily Reckoning. His “trade of the decade” — sells stocks, buy gold outlook — now looks like a very wise move. Bill says we about to be hit with a protracted bear market combined and a deep recession.

“When Mr. Market goes into a sulk, he takes a long time to come out of it. Real bear markets last 10… 15… 20 years. Judging by the meltdown in the financial sector and the rapid losses we’ve seen over the last three weeks… we have a real bear market on our hands…

“With no more easy credit available to them, consumers are doing what they have to do — they’re cutting back. How much? For how long? No one knows the answers to those questions, but our guess is this: more and longer than you thought.”

– We didn’t expect permabear Nouriel Roubini to be calling a bottom. But we didn’t expect such a bleak prognosis either. Roubini spoke yesterday morning on CNBC. Henry Blodget on Clusterstock summarizes Roubini’s breakdown of the coming financial Armageddon:

# The worst is yet to come.
# The next few weeks and months are going to have lots of negative surprises on the economy
# The flow of market news is going to be much worse than expected–just like last week when every piece of news was awful
# Earnings are going to surprise on the downside. There’s going to be a sharp fall in earnings, not just financial sector, but everywhere.
# Even in financial system, where we avoided a systemic global financial meltdown by an epsilon, there will be significant risk downward. Emerging markets going into a crisis. Having a blow up of the CDS market. Having hundreds of hedge funds closing down.
# So I significant downside risk for the financial markets and economy. I think the worst is yet to come.

– Blodget says yesterday’s wipeout in the stock market was a good thing, because it means the market is behaving rationally.

Trading down on profit warnings is a pretty rational and even normal response to economic news. The reason that’s good news is that it means we’re not just experiencing mysterious problems in credit markets or some new financial innovation no one ever heard of exploding all over the markets.

– Argentina, where the ContrarianProfits offices are based, is royally screwed by the looks of things. The hugely unpopular president President Cristina Fernandez de Kirchner has announced she will seize pension funds. Cristina, ever the populist, claims the move is to “protect” people’s money. The reality is she plans to use the funds’ $29 billion to meet the country’s spiraling financing needs. The Argentine stock exchange, the Merval, plunged as much as 18% on the news.

– Addison Wiggan’s take on it in The 5 is dead on.

Beset with debt and overcome by its bond obligations, the Argentine government nationalized $30 billion in private pension funds yesterday.

Fifty-five percent of those pensions are government debt holdings… and now that Argentine leaders have seized them, they can essentially write them off. The rest of the holdings they’ll use to finance debt payments and keep the government running.

Argentina is the second largest economy in South America. It is one of the world’s top five exporters of beef, soy, corn and wheat. It still can’t afford to keep the lights on. Argentine citizens are being asked to suspend reality and trust the government is good for the money when they’re ready to retire.

Hmmmn… puts us in mind of that ’70s-era Rainbow rock ‘n’ roll tune “Can’t happen here, can’t happen here. All that you fear, they’re telling you, can’t happen here.”

This from today’s Daily Reckoning:

The boom in construction has been over for nearly two years…

The boom in the financial sector ended about 12 months ago…

The boom in the aviation industry died when oil went over $100…

The boom in commodities was killed when oil went under $100…

The boom in retail seems to have come to a halt more recently. This will be the first quarter in many years with declining consumer spending… The boom in consumer borrowing seems to have come to an end, too…

Yes, dear reader, what MUST happen, DOES happen. But it usually happens when you don’t expect it… or in a way that surprises you. The big surprise has been the violence of the correction when it finally got going.

“Day of Reckoning,” the Telegraph called it.

But we should be happy. Not only is the mainstream media picking up our themes, now both sides of our Trade of the Decade are working. Yesterday, the Dow went down another 189 points. Gold went up $29.

But instead of joy and satisfaction, we feel a sense of dread. It’s all very well to have a few kruggerands and gold louies stashed somewhere… but you can never have enough of them to brighten up a darkened world.

As an insurance policy against a financial catastrophe, gold still works – perhaps better than anything. But who wants his house to burn down so he can collect the fire insurance?

[Editor’s note: You can download your free report “Buying Gold Coins for Financial Profit & Protection” here.]

Guess how much Americans have lost so far from the stock market decline? Almost $5 trillion. Stocks are down about 33% from their ’07 peak – resulting in the destruction of wealth on an unprecedented scale.

Add to that the loss of wealth in the domestic property market, and you can’t help but wonder… how do people keep going? The Wall Street Journal reports that one in six homeowners is “under water” – with more mortgage than house.

“About 75.5 million U.S. households own the homes they live in. After a housing slump that has pushed values down 30% in some areas, roughly 12 million households, or 16%, owe more than their homes are worth, according to Moody’s Economy.com.”

And house prices are still going down.

Yes, that is something that MUST happen too – house prices have to go do to the point where people can buy them. The average house must be affordable to the average homeowner. And since incomes haven’t gone up in the last 8 years, we can presume that housing prices shouldn’t have gone up either.

So, we ask… how much more do houses have to fall before they are back to where they were 8 years ago… or merely to the multiple of income that buyers can afford? The answer… according to the numbers we’ve seen…is about 20%.

That suggests that we are only about half way through this housing decline. It further suggests that when it is over one out of every three homeowners could be in serious trouble. He may not be under water, but he will definitely be up to his neck.

And now it gets worse.

Because practically every businessman in America is waking up this morning thinking about how he can cut costs. His sales are going down. What choice does he have? He has to cut his payroll. And so, he begins making a list… which employees are essential to his business… which are not. Overtime is cut. Part-time workers are scaled back. Full time workers are let go. He knows the woman in the mailroom is a waste of money, but she’s nice to look at. The fellow running the advertising is an idiot, but he can’t stop advertising, can he? And how ‘bout that driver…he seems to disappear for half the day; he’s never where he’s supposed to be… yes, he’ll be fired immediately…

And then, the world’s lights grow dimmer.

Source: The Boom Years Are Over

For a while now I’ve been writing that if you can integrate a historic shift into your investment strategy you may come out ahead. The shift is this: that America actually did lose the Cold War.

This became apparent to me about a year ago when we saw the economies of our old Cold War enemies, Russia and China, continue to thrive as our own free market economy literally started to melt down.

Now with Washington bailing out AIG, it seems that our Cold War defeat is undeniable. The very same foreign-policy package of democracy, free-market capitalism and laissez-faire government that Washington has been peddling to emerging economies and Middle-East despots has turned into a profound embarrassment.

Worse, Washington’s seizure of AIG clearly puts us in the camp of our former Cold War rivals in terms of socialist capitalism.

Why is this import to you as an investor?

Look no further than the hedge fund managers, traders and executives of the Wall Street institutions that now find themselves broke. They conducted themselves like Cold War victors. They acted as though the US was still on top could get away with anything.

They were empowered by the free-flow of instant information across global networks. They mistook superior technology for superior government, and with this fatal flaw everything came crashing down around them.

Many pundits argue that greed overran the system. In turn, I would say that a lack of humility is a better interpretation. We dominated the markets with the arrogance of Cold War winners, when in fact it is now painfully apparent that we lost years ago.

By contrast, if you look at America through the lens of a Cold War loser, other stock markets become more attractive – not just through a technical analysis but more through qualitative attributes that give you a better long-term perspective of the possibilities.

After World War II, while much of Europe was in ruins and much of Asia was feudal, it was easy for us to believe that we would be on top forever. Certainly the destruction of the Berlin Wall gave us that self-righteous pat on the back and lionized the Cold War doctrine of Reaganonics. And when you look at the Hollywood box office figures and see how much of our entertainment is shipped overseas it sure makes you believe that everyone wants to live like an American.

But does everyone want to invest like an American?

National pride and patriotism are fine, but do they really have a place in your portfolio?

More from Eric:

No automatic connection exists between greed and poor stock market performance. But bad things just seem to happen to the common shareholders of companies that greedy managements oversee. Names like Enron, Tyco and Worldcom come to mind.

In this context, names like Merrill Lynch and Morgan Stanley do not yet come to mind. But the big brokerage firms of Wall Street have veered perilously close to the shoals of excessive greed. And this course endangers shareholders because it squanders capital that could be funding productive activities, or providing a balance sheet buffer against future unanticipated “adverse outcomes.”

As long as the financial markets remain robust, however, no one will care how many billions of dollars might slosh into the brimming bank accounts of elite traders and top Wall Street insiders. But financial markets are not always robust. The same Citigroup (C) that is today lavishing billions on its top employees was once the Citibank that flirted with bankruptcy in the early 1990s.

Bank and brokerage stocks are already risky enough, thanks to the perennial risks of falling financial markets, rising interest rates and exploding derivatives books. Avaricious management teams do not lessen these risks.

The owners of brokerage shares, therefore, do well to remember that Wall Street is forever and always about money. It is about making as much money as humanly possible, in as many different ways as legally defensible. Wall Street is not about charity or altruism or the “greater good.”

Wall Street is also about survival of the fittest – the ‘fittest’ being those who maneuver themselves into obscenely overcompensated positions. Do these alpha-bankers and alpha-traders deserve their millions? In a primal sense, yes…just like a great white shark deserves a slow-moving harbor seal…or a falcon deserves a hapless bunny…or a coyote deserves the neighbor’s dozing Pomeranian.

But these metaphors become a bit sinister when one realizes that the “hapless bunny” and the “dozing Pomeranian” are the common shareholders.

The big brokerage firms make most of their money by speculating with capital that does not belong to them, or by levying fees and commissions on capital that their clients put at risk in the financial markets. In other words, shareholders and clients bear most of the risks. Yet whenever any form of success arrives, Wall Street’s elite always garner an outsized share of the rewards. That’s asymmetry. And in this case, asymmetry might just be another word for greed.

Consider the case of Morgan Stanley. The firm posted net income of $7.4 billion in 2006 – an impressive $3.7 billion more than 2003 earnings. But at the same time, total compensation at Morgan Stanley last year topped $14.3 billion – a whopping $5.8 billion more than in 2003.

Does it not seem odd that employee compensation is nearly twice the firm’s net income? And does it not seem odd that employee compensation has jumped 60% more than net income since 2003, even though the number of employees has barely increased at all? In fact the employee count has DROPPED since the end of 2002.

Most of the individual recipients of year-end bonuses are not to blame, of course. They are simply blessed. And as blessed individuals, they enjoy the privilege of sharing their wealth in altruistic and charitable ways…or not. Likewise, the stockbrokers who toil for these firms deserve no scorn. They earn their keep like entrepreneurs, and must conduct their activities in a very open and competitive marketplace.

But the leaders of Wall Street – those who perpetuate the status quo – might consider taking a minute of “quiet time” to consider the propriety of their practices. Do these folks honestly believe that they deserve their multi-million-dollar bonuses, simply for presiding over bull market trading activity? And do they honestly believe that “star” traders deserve their multi-million-dollar bonuses, simply for speculating with someone else’s capital.

To re-phrase the question: Isn’t it possible that Wall Street’s elite employees should receive a somewhat smaller share of corporate cashflows than they do currently…and that the common shareholders should receive a somewhat larger share?

“Nobody who is hired help and who plays with other people’s money ‘deserves’ to earn $100 million,” gripes Steven Pearlstein in a terrific article for the Washington Post. “That’s certainly true in a moral sense. But it is also true economically…Let’s start with the fundamental asymmetry of risk in the investment business.

“If you were putting your own money at risk,” Pearlstein continues, “there’s the possibility of making lots more, but there’s also the possibility you could lose it all. The same, however, can’t be said if you are an investment banker, a hedge fund manager or a trader in credit default swaps. In that case, if you do well, you get a percentage of the winnings or the value of the deal. But if you do poorly and your clients lose money, the worst that happens is that your bonus is zero. You never have to give back anything from the bonus you earned last year. And you still get a base salary comfortable enough to keep up payments on the Upper East Side townhouse, the summer place on Nantucket and the tuitions at Brearley.”

No one cares about over-the-top compensation schemes when business is booming…and when share prices are rising. But on the downside, everyone cares. During the Great Bull Market of the late 1990s, almost no one bothered to question the exorbitant option grants that Silicon Valley companies lavished on their employees (and on their board members!)

But once the Great Bull Market ended, and the Nasdaq imploded, a new bull market in recrimination and litigation began. Class-action shareholder lawsuits erupted from the smoldering remains of former Wall Street darlings, as desperate shareholders tried to recover some small fraction of their losses.

Would it not have been much better for these abused shareholders to sell when the selling was good? Would it not have been better to have raised a skeptical eyebrow toward the questionable corporate practices of the era and headed the other way…even though questionable corporate practices were producing rising share prices?

“Excess compensation in one area leads to excess compensation in others, “Pearlstein concludes. “And that, in the end, is how this arms race in executive pay comes about. It’s more about envy than economics. The corporate executives complain they should make as much as the investment bankers, the bankers are upset if they don’t make as much as the private-equity guys, the private-equity guys demand to make as much as the traders, and the traders won’t sit still until they are paid like hedge fund managers.”

Excess compensation also leads to sub-optimal shareholder returns. Greed and capital preservation just don’t seem to mix very well, especially when the greed belongs to someone else and the capital belongs to you.

Source: Bonus Envy

In other words, says Eric Fry at Rude Awakening, Wall Street could have avoided the whole mess by applying some restraint and foresight. It didn’t.

The lesson to be learned from Wall Street’s hubris, says Eric, is that although stocks can be ruined by over zealous management, commodities cannot. Stupidity is not a risk factor in the commodities sector. And this makes them attractive despite their recent selloff.  

More from Eric:

What separates an epic financial crisis from a merely ordinary one is the scale of the resulting destruction. The current credit crisis is epic in almost every imaginable way. Very few investors have managed to escape its fury.

For most of the last 14 months, some wary investors managed to escape harm, simply by avoiding financial stocks…and/or by hiding out in the commodity sector. But as the crisis has intensified, reliable hiding places have all-but-disappeared. In fact, many hiding places are starting to feel a bit like tombs.

As recently as the end of August, many commodity-focused investors were savoring modest gains for the year-to-date. But the first two weeks of September have demolished those gains, along with the comfortable illusion that commodities would provide a reliable hedge against stock market losses. Even gold has failed to provide any refuge – slumping more than 5% in September alone.

Therefore, many of us resource investors are feeling more chagrin than satisfaction. We sidestepped the financial sector 18-wheeler, only to step in front of the commodity sector bus. But at least we’re still flinching on the pavement…unlike our bank-stock-investing counterparts. We should remember that Merrill Lynch stock has delivered a total return of MINUS 45% during the last 10 years! Commodity prices have nearly doubled over the same timeframe. So all of you commodity investor who gravitate toward self-flagellation might want swing the whip a little more gently. Your misery is not entirely your fault. These are very unusual times in the financial markets.

Typically, stocks and commodities move in opposite directions. Therefore, the investor who feared a selloff in the stock market could usually protect himself by loading up on commodities. But not in September of 2008! During the recent stock market selloff, commodities have provided no protection whatsoever. In fact, they have performed even worse than stocks.

A hypothetical portfolio that contained half S&P 500 stocks and half commodities would have lost 9.75% during the month of September, so far. That performance would rank as the fourth worst monthly performance of the last 50 years. In other words, these are strange times indeed.

But even though commodity prices have retreated substantially from their all-time highs, they will rebound eventually. By contrast, the financial sector has wiped out more than one trillion dollars of investor wealth…and that wealth is gone for good.

So at the risk of repeating ourselves, we will repeat ourselves anyway: we like commodities, at least for the long haul, if not also for the short haul. We like commodities because supplies are limited and demand is not. But we also like commodities because they lack CEOs and executive management teams. We like commodities because greed and stupidity cannot destroy their value.

Source: Bonus Envy

– The crisis on Wall Street could be felt all around the world this morning as global stock markets tumbled. Japan and South Korea, whose markets were closed for a holiday yesterday, saw the worst of the selling. Their stock markets dropped 4.95% and 6.1% respectively. Hong Kong, Taiwan and Australia also suffered heavy losses.

– Britain’s benchmark FTSE 100 index hit a three-year low, trading down 2.7% at 5,065.90.

– Ratings agency Standard & Poor’s has slashed WaMu’s credit rating to junk. The bank’s credit rating is now BBB-, three grades below investment grade. Standard & Poor’s said it made the decision based on market conditions, not any fundamental change in the financial condition of the bank.

– Central bankers scrambled to calm the crisis and inject much-needed liquidity into the markets. This from Bloomberg:

The Federal Reserve added $70 billion in reserves to the banking system, the most since the September 2001 terrorist attacks, to reverse a surge in borrowing costs sparked by the collapse of Lehman Brothers Holdings Inc.

Fed funds traded as high as 6 percent, or 4 percentage points above the central bank’s target rate for overnight loans between banks, according to ICAP Plc, the world’s largest inter- dealer broker. The margin was the greatest since Bloomberg began tracking the data in 1998. The rate dropped to as low as 0.5 percent after the Fed added the temporary reserves.

– Speculation is mounted as to whether the feds will cut rates further at today’s Federal Open Market Committee meeting. According to Bloomberg: “Fed officials were deeply involved in the urgent weekend meetings at the New York Federal Reserve Bank that culminated in the decision by Lehman Brothers Holdings Inc. to seek bankruptcy protection and Bank of America Corp.’s acquisition of Merrill Lynch & Co.”

– Central banks in Europe also intervened this morning. The European Central Bank pumped just under $100 billion of emergency funds into the market. The Bank of England, meanwhile, which added $9 billion worth of funds yesterday, added a further $35.8 billion this morning.

– The crisis weighed heavily on sentiment on oil prices. Crude fell over 4% to a seven-month low today. It hit a low of  $91.11 a barrel.

– Gold is up on safe-haven buying. But there has been no major breakout. Kitco.com shows New York gold at $784.70/785.90 at 8.28 EST.

The Bear Stearns bailout was supposed to prevent the crisis from rippling through Wall Street. Obviously it hasn’t done that. It’s merely thrown the crisis into slow motion and prolonged the agony.

– Addison Wiggan and Ian Mathias in The 5 Min. Forecast have a different view: The government is not willing to bailout another bank…

Long story short, Lehman is as close to going out of business as ever. The firm is still gripped by credit- and mortgage-related losses. Its merger with a government-owned bank in Korea is now rumored to have fallen through. S&P has threatened to cut ratings, again. And the market is terrified that the U.S. government is not willing (or even able) to bail out ANOTHER “too big to fail” financial.

– Selling hits Lehman’s stock.

– Lehman is “ripe for a hostile takeover,” says Jennifer Yousfi in Money Morning. But the clock is ticking. According to Jennifer, “As the list of potential saviors continues to dwindle, so does investor confidence in Lehman Brothers.”

– US futures are pointing down. “Stocks head squarely toward sharp losses as financial  worries and slowdown jitters call the tune.  Data on trade, jobless claims and import prices on deck. 

–  There’s always a way to profit. Martin Hutchinson in Money Morning says as Treasury bonds suffer from higher government borrowing and inflation the Rydex Juno Fund (MUTF:RYJCX) should see major gains. Ian Davis in DailyWealth says it’s difficult to see how investors can lose on fat-dividend paying Taiwanese stocks.

– The dollar continues to rally. It hit a one-year high against the euro and a basket of currencies.

– Charles Delvalle in Investor’s Daily Edge says investors should factor in 6 to 12 months of dollar strength after the buck broke above its eight-year resistance line.

– The rising dollar is having having a negative effect on crude oil prices. Prices are down to just under $102 a barrel.

– Chris Mayer, however, remains bullish on oil long-term future for two fundamental reasons.

– Gold prices regained some strength. Reuters reports that “investors who propelled gold to a lifetime high of $1,030,80 in March on inflation fears and a struggling dollar are ditching their bullion holdings as the US currency stages a dramatic rebound.”
– Lee Lowell at The Smart Profits Repor, however, gold is oversold. He also says the dollar rally is mainly due to sentiment.

The bailout of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) means two out of three of the nation’s GSEs are backed by the taxpayer. However, they remain publicly traded outfits beholden to their shareholders.

The question, then, is: What happens if Fannie and Freddie, enjoying the backing of the government, venture into riskier areas of consumer finance to boost earnings. Are we looking at the spread of nationalization beyond the mortgage market?

This from Chris:

It is interesting to note that the GSEs are among the most leveraged of all US industries. Only federally insured commercial banks and savings institutions exceed their debt ratios. Moreover, as Cochran and England point out, if you add back certain off-balance-sheet liabilities (like mortgage-backed securities which the GSEs guarantee) there is approximately $80.55 of debt for every one dollar of equity in Fannie Mae and $64.70 in debt for every one dollar of equity in Freddie Mac.

The fact that the market implies that GSE obligations are backed by the US government only adds to their ability to further leverage their assets. Perversely, as Cochran and England note, “the ambiguous nature of the GSEs’ relationship to the government may reverse customary market incentives. In sharp contrast to the concerns that arise when a private corporation increases its outstanding debt, investors in GSE debt could expect that the more debt Fannie Mae has outstanding, the less likely the government will be to allow it to default. Some investors may thus interpret increased GSE debt as embodying less risk rather than more.”

The risk to the GSEs is that an economic downturn results in falling home prices, increasing delinquency rates and thus leading to loan losses. With the GSEs’ high leverage, it won’t take much in the way of losses to cause some significant damage to their financial health. As James Grant recently observed, “Ignorance about tomorrow is a constant of human affairs. Submission to this truth is what’s variable. In finance, submission entails a healthy fear of leverage.” The GSEs are operating as if the future is certain and prosperous.

An explosive concoction has been created with the GSEs. The GSEs have increasingly dangerous levels of debt, coupled with an implicit government guarantee that seems to encourage even more debt. In the case of Fannie and Freddie, they are publicly traded companies accountable to shareholders for delivering earnings growth that is going to be increasingly difficult to deliver as they grow to the limits of their market. Thus, they are faced with the prospect of lower earnings growth or of finding a way to expand into other (riskier) areas of consumer finance – and further spreading the threat of nationalization beyond just the mortgage market.

The only way to correct this problem is the same way all socialistic practices are corrected – the government’s involvement must be severed completely. Just because the GSEs have led a charmed life so far is no reason to infer that their future will always be so bright. Socialism is not dead; it is alive in institutions like the GSEs, which are for all practical purposes government agencies.

It has often been said that there are no free lunches. Surely, Americans cannot continue to subsidize (indirectly) mortgage finance without cost. What most Americans cannot see is that such subsidization of the mortgage industry has led to the assumption of a great deal of risk on the part of the taxpayer. The longer the GSEs are able to expand as they have, the more certain it becomes that someday taxpayers will have to bear the cost of such excess. Like Russian roulette, the longer you play, the more certain it becomes that you will bear the risk for playing.

Source: Mortgage Market Socialism

– This morning, the bad news continued for Lehman. It told Wall Street it will post a second straight quarterly loss but promised to slim down in the future, putting an end to a brief pre-market rally in its shares.

– The futures of the nation’s smaller banks isn’t exactly rosy, either. Rumor has it that Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) has “told one of its subsidiaries to stop insuring bank deposits above the amount guaranteed by the federal government.”

– The government’s multi-billion-dollar social welfare program for Wall Street continues to make news. Regarding the bailout of Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FNM), Forbes asks a surprisingly good question: Why is it necessary to inject taxpayer funds into these companies as equity?

Ordinary companies need capital so that they can meet their obligations, but both these companies will have access to a financial facility at the Treasury that will allow them to borrow all the funds they require.

They don’t need capital. The injection of capital is, in fact, a gift to the existing shareholders, who–as the owners of insolvent companies–own nothing and deserve no benefits from the taxpayers. By injecting these taxpayer funds and enabling the companies to survive, the Treasury plan opens the possibility that the existing shareholders will eventually profit from their investments, when, by all rights, they should be wiped out.

Instead of conservatorship, says the mag, which keeps the status quo, the government should have but the toxic twins in receivership.

Could the government’s judgment on the matter was clouded by all the money Fannie and Freddie lobbyists were throwing at it? Fannie and Freddie spent $7.4 million on lobbying in the first six months this year. Since 1998, they have flung $174 million at the nation’s public servants.

– Yesterday, Jim Rogers called the bailout “socialism for the rich.” “This is madness, this is insanity, they have more than doubled the American national debt in one weekend for a bunch of crooks and incompetents,” Rogers said. “I’m not quite sure why I or anybody else should be paying for this.”

– Despite all this, the dollar is continues to defy gravity. This from yesterday’s 5 Min. Forecast:

Incredibly, the dollar continues to rally. The dollar index is currently hovering around yesterday’s high of 79.7. If you’re a chartist, keep your eye on that 80 level… it’s been a rallying point for the greenback ever since the dollar index was introduced.

– However, GoldMoney’s James Turk, quoted in the 5, says this is “this bounce has all the characteristics of a bear market rally. It is sharp and swift and happened without any change for the better in the fundamental outlook for the dollar.”

In fact, if it has changed at all, the outlook for the dollar has worsened, which is the first reason to suggest that the buck stops here, namely, that its bear market rally is ending. As the recession in the U.S. deepens, the probability of the Federal Reserve raising interest rates anytime soon has fallen. Consequently, real (i.e., inflation-adjusted) U.S. dollar interest rates remain negative.

– Eric Roseman, The Sovereign Society’s investment director, agrees with James. Yesterday, Eric said the commodities correction will be short lived, thanks to a lack of real support for the greenback. He recommended picking up oil, drillers and gold stocks in anticipation of a commodities bounce.

– This morning, oil climbed $1.12 to $104.38 a barrel on news that OPEC has moved to reduce output levels. If you’re looking for a reason why oil is still way off this year’s peak, Rick Pendergraft at Investor’s Daily Edge has an interesting theory. He says the goverment’s recent ban helped killed oil prices.

– Finally, gold has staged a recovery in Europe on Wednesday after hitting an 11-month low in Asian trade. Reuters reports that “spot gold was at $775.50/776.60 an ounce against $775.80/777.80, well off its session low of $762.55 an ounce, its weakest since Oct 2007.”

–  Commodities expert Lee Lowell at The Smart Profits Report reckons gold is oversold:

Gold topped out right near $1,000 an ounce back on July 15 and has given up roughly $200 an ounce since then – a $20,000 move in equity.

As with the other commodities, that’s a big swing. And just like silver, gold is oversold and could see just as impressive a bounce if people start to pile in.