Collateral Damage in the Subprime Market

Tomorrow, America’s great middle class will celebrate in a great middle class way – with picnics, crab feasts, and outdoor barbecues.

The conversation is likely to turn to housing. But unlike the sunny July 4th holiday discussions of recent yesteryears, tomorrow’s beery dialogues may be a bit overcast.

The United States is suffering the worst slump in the housing market since the ’30s, say the news accounts. How bad is it, really? That’s hard to say. The national statistics show a modest decline in prices – or even an increase, in some areas – with mounting inventories of unsold houses. In Las Vegas, the number of resold houses in May this year dropped by 28% from last year.

The wheels of Financial Fate may grind slowly…but they grind exceedingly fine. And America’s middle class is beginning to notice.

“Home values and the $6 trillion U.S. mortgage-backed securities market are locked in a downward spiral,” reports Bloomberg.

Bloomberg describes where the abstract – such as CDO pricing – hits the concrete – such as the cracked stone driveway.

“Bear Stearns is bailing out one money-losing hedge fund it controls and leaving another to liquidation by creditors. Both funds invested in securities backed by subprime loans. The loans, for borrowers with bad or limited credit histories, are secured by houses such as the one on Lilac Lane [in Decatur, GA].

“Bear Stearns took possession of the three-bedroom Lilac Lane house for $76,500 on March 6, according to the foreclosure deed. The owner who defaulted had purchased the house in April 2005 for $160,000 using a subprime loan that required no money down. He had been renting it out, according to the neighbor.”

The local mortgage lender went bankrupt…the house was repossessed and sold for half the previous price. Then, rented out, its condition deteriorated. The paint flaked off. The concrete cracked. Possums moved in to the backyard.

And now, the proud owner is Bear Stearns (NYSE:BSC). The second biggest underwriter of mortgage-backed securities in the United States is rapidly becoming also a major owner of split-levels, neo-colonials, and Spanish-style bungalows.

Bloomberg adds:

“Bear Stearns and its affiliates are listed as buyers of at least 53 homes so far this year in San Diego County, California, 48 in Maricopa County, Arizona, and 40 in Cuyahoga County, Ohio, according to a search of property records.

“JPMorgan, the third-largest U.S. bank, and its subsidiary Chase Home Lending acquired at least 194 homes this year through foreclosure in Wayne County, Michigan. Merrill, the third-biggest securities firm by market value, and its mortgage unit, First Franklin, took possession of at least 87 homes this year in San Diego County, California. Citigroup and affiliates are the new owners of at least 47 homes in Clark County, Nevada.

“‘Our expertise is in lending money to people to buy homes, it’s not in owning homes,’ said Chase Home Lending spokesman Thomas Kelly.”

What’s Bear Stearns going to do with the places? It can let Mr. Market do his work – putting the houses on the market and accepting whatever price he gives. But if it sells, it risks depressing prices of other homes in the area – many of which it owns! What’s worse, “it will have a decimating effect on the mortgage-backed securities market when lenders start facing the music and letting property go at whatever price people will pay,” says a local lender. But what did Bear Stearns expect? When its collateral goes down in price, so do the financial abstractions that rested upon them.

On the other hand, lenders can turn their backs to the music. But the music keeps playing. That is what the neighbors are likely to be talking about tomorrow: The possums…the cracks…and the predicament in which Bear Stearns finds itself. It can sell…or it can hold on, maintain, and try to rent. But whichever way it goes, woe awaits.

Faced with a similar situation in its sophisticated hedge funds, Bear Stearns decided not to let Mr. Market have his say…at least, not just yet. Rather than mark its portfolio of CDOs to market – by staging an auction of the assets in its troubled hedge funds – the company thought it best to keep things under tight control…putting off the day of reckoning, hoping that conditions in the CDO market might improve.

“What’s really scary about this recent trend is that many mortgage-backed security portfolios are ‘marked to model,’ rather than ‘marked to market,'” Strategic Investment’s Dan Amoss told us today.

“This means that they’re carried on the books at whatever the in-house math geeks think they’re worth. There’s no liquid secondary market for many of these securities, so this often serves as the only way to account for them.”

Market conditions for collateralized debt obligations don’t look so good. But neither do conditions for the collateral itself. Perhaps, Bear Stearns may be thinking, if it can just keep the possums out of the house on Lilac Lane, the place will be saleable, say, in a year or so, at a higher price.

“If this mortgage-backed security mess gets worse, there’s a good chance that a ‘ratings agency’ scandal could unfold in the coming months – one that resembles the investment banking scandal of 2001-2002,” Dan continued.

Then again, with so many people thinking the same thing, how likely is it that it will work out for them all?

“Steer clear of stocks like Moody’s and McGraw-Hill,” advised Dan, “they’re exposed to the ratings business.”

At this month’s editorial meeting in Baltimore, Dan asserted that he sees this mortgage-backed security debacle as the next Enron…which could turn out badly for countless investors – but not for those listening to Dan’s advice.

Like Jim Chanos, who made a fortune betting against Enron, Dan has a nose for finding holes in seemingly “healthy” companies – and now he’s offering his readers a way to profit from a shoddy company’s fallout. He is launching Strategic Short Alert, a new trading service that will focus on shorting stocks and buying put options.

Strategic Short Alert will cost $1,495 a year…but for the next 48 hours, you can get your subscription for free.

Bill Bonner
The Daily Reckoning
London, England
Tuesday, July 3, 2007

More news:


Addison Wiggin, reporting from Baltimore, hon…

“Here we go again… retail prices for beer in at supermarkets in America rose 3% in May — the biggest increase in 2 and a half years. According to this morning’s USA Today, many farmers who used to grow barley have switched to corn. Barley prices are up 17% this year and sitting on an 11-year high. It was one thing when we learned the price of beer was rising in Germany, but this…

“‘This we can’t stand!’ exclaims Greg ‘Grizzle’ Grillot, managing editor of Whiskey & Gunpowder. ‘First gas…then milk…then pork…then even my damned tortillas. But beer! How can I stomach Independence Day while suffering from this nasty inflation?'”

For more market insights, see today’s issue of The 5 Min. Forecast


And more thoughts:

*** What happens when the middle class loses ground?

Pundits whine. Politicians rant and rave. Bashing the rich becomes more popular. Resentment rises. Envy increases. And so do tax rates.

The rich cease being objects of admiration. They become “filthy.” Roger Cohen, writing in the International Herald Tribune, bemoans the fact that while the “filthy” rich get even richer, “fabulous wealth creation has been unmatched by improved education. Teaching that will get you recognized in a global world is denied minority kids in failing schools.”

We don’t know what that means…maybe he means that people who teach minority students are dumbbells. And maybe they are. And maybe he thinks paying them more money will make them smarter.

Poor Mr. Cohen. He has so much faith in the rich! He thinks they can do anything. Hedge fund managers expertly exploited this go-go credit bubble market; now they can do something about public education!

“Hedge fundocrats…should consider ways to pile money into ending this national failure.” What faith he has…in people with money…and in money itself. Pile it on. Push it in. Stack it up. Is there any problem more money can’t solve? Money has been pouring into “education” for the last four decades – while educational achievement levels fell. Still, Cohen thinks more money is the cure…not the problem.

Then, of course, he goes on to want to take money away from the people who have more of it. The rich get much of their money from capital gains, he complains, which are only taxes at a 15% rate, rather than the 35% top tax rate.

Expect more of this, dear reader. Brace yourselves.

*** Henry, 16, came back to London with us. He’s doing a one-month internship at MoneyWeek magazine.

It’s never too soon for Spartan office cubicles…the discipline of routine…the sturdy ethic of 9-to-5.

“The poor boy,” commented MoneyWeek editor Merryn Somerset Webb.

“He doesn’t look ready for office work. He looks so happy. So well adjusted. So youthful and full-of-energy.”


The Daily Reckoning PRESENTS: The Chinese are expanding there railway system by leaps and bounds…and recently, two of the world’s most savvy investors took a sudden interest in the good old railroad business. It’s clear: the rails are back. Chris Mayer explores…


Experts called it the most difficult project in the history of railways.

Imagine it. Chinese engineers laid 690 miles of track from Golmud, in the Qinghai Province, to Lhasa, the capital of Tibet. They did it in less than four years. In typical Chinese fashion, that was three years ahead of schedule. About 38,000 workers advanced more than half a mile a day. At times, they had to tunnel through ice and rock with temperatures as low as 31 degrees below zero.

Swiss engineers, who have some expertise in matters of tunneling through mountains, thought no one could get through the Kunlun mountain range. The peaks of Kunlun wear snow hats year-round. Passes weaving through the range still climb more than 15,000 feet. Oxygen is at a premium up there. Then there is the steepness of the grades the trains must climb. They are steeper than any railroad anywhere in the world.

Yet the Chinese have their railroad, and more are on the way. China has more than 32,000 miles of track. The Chinese ambitiously add to that total every day. Demand for rail service is high. During peak season, China’s rails carry more than 5.2 million passengers a day.

In the last week of May, China introduced its first bullet trains – 280 cars capable of traveling up to 155 miles per hour. Now you can get from Beijing to Shanghai in 10 hours, instead of 12. Tickets sold out quickly.

China’s railroad revival is not unique to China. All around the world, it’s becoming clear: The rails are back.

In the U.S., several savvy investors have taken a sudden interest in the good old railroad business. Warren Buffett recently bought stakes in three freight railroads: Burlington Northern Santa Fe Corp., Union Pacific Corp. and Norfolk Southern Corp. He was not alone.

Billionaire and fellow investing legend Carl Icahn also picked up some railroad shares. He bought a $122 million stake in CSX Corp. King Carl’s interest in the railroad story runs deep. He is also chairman of American Railcar Industries Inc., a manufacturer of railroad tank cars.

What’s especially interesting is that these old warhorses – famous bargain hunters, both – took their positions as these stocks were making new highs. The Standard & Poor’s 500 railroads index has more than doubled since the end of 2002. It’s up another 23% in 2007 as I write.

As The Economist recently noted: “It’s been a long time since railways have become so fashionable.” The ever-sober magazine recounts bits of the railroad industry’s sad history. Railroads were once the dominant choice for intercity traffic, with 75% of the market in as late as 1929. By 1980, that share fell to 38%, as new roads and trucks ate into their share of the pie. About a third of railroads lost money. Deregulation, begun that year, set off a 20-year period of restructuring and consolidation. Only seven of 31 Class I railways survived this lengthy and brutal bear market.

But those surviving railroads are making big profits. “Strong demand for coal, agricultural and container services – the ‘holy trinity’ of freight – has trains running at full steam,” says The Economist. The railroads gush cash, some of which they pay out in higher dividends and to buy back stock. The rail renaissance is on.

Some of this story links to China, as these things always seem to these days. Railroad companies are busy laying track and building terminals to accommodate tens of thousands of containers coming into this country every day – many from China. We are in the midst of a great cargo boom, the effect of which also extends to the rails. More and more of that freight gets loaded on railcars, as opposed to a truck trailer.

Trucking costs are high. Truckers struggle with the high prices of gasoline and diesel – trends not likely to reverse anytime soon. High oil costs hit trucking much harder than they hit railroads, which are three times more oil efficient, as Buffett has pointed out. Trucking companies have difficulty finding long-haul drivers and face high insurance premiums. Increasing gridlock in most cities makes delivery a little less reliable.

Another reason for the rail revival: the rise of cities. We are at a tipping point in world history: By the end of this year, more people will live in cities than not. Many of these cities suffer the same problems: congested roads and lack of urban land.

Therefore, there is a growing premium on urban space. Cities and developers must look at better ways to use existing space. Increased reliance on rail helps this effort. Rail delivers large numbers of people and freight without taking up much precious urban land, as compared with accommodating increased car or truck traffic – or even building an airport.

The rails also help stave off gridlock on the overcrowded roads of the world’s cities. More traffic by rail may absorb people and freight that otherwise would have gone by car or truck.

The rails appease the green crowd, too. Air travel is a big polluter. Flying results in twice as much air pollution as traveling by rail. Airlines also struggle with the high cost of fuel.

All of these reasons factor into the railroads’ recent popularity with investors. You could go out and buy any of the railroads yourself and gain exposure to this trend. Take a ride along with Buffett and Icahn and other savvy investors who are also buying railroads.

There is always a crisis somewhere at some stage of development – some just beginning, some in bloom and some just ending. In the case of the railroads, it looks like their long stretch of troubles is over. The rails are back.


Chris Mayer
for The Daily Reckoning
July 3, 2007

Editor’s Note: Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer’s essays have appeared in a wide variety of publications, from the Daily Article series to here in The Daily Reckoning. He is the editor of Mayer’s Special Situations and Capital and Crisis – formerly the Fleet Street Letter.

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