The $8.4 billion write-down announced by Merrill Lynch & Co. Inc. (MER) last week was just the latest in a series of similar revelations by Bank of America Corp. (BAC), Citigroup Inc. (C), The Bear Stearns Cos. (BSC) and Lehman Brothers Holdings Inc. (LEH). And it underscores the key challenge investors continue to face: You don’t know what a company’s assets are really worth, so a company’s portfolio can explode into a mushroom cloud of red ink at any given time.

Even worse, the problem is not limited to the banks and brokerages that have already suffered explosive write-downs. It could well include the top-drawer institution, Goldman Sachs Group Inc. (GS), which hasn’t yet reported a big write-down. Later on, I’ll tell you why.

Until Wall Street cleans up its act in the risk-management area, there’s really only one smart thing to do: Stay as far away from the sector as possible – perhaps even seeking shelter in the Wall-Street-proof emerging markets.

Accounting for Future Assets

When the first round of write-offs came out, investors figured that one bad quarter would put the subprime mortgage problem in the rearview mirror, and allow Wall Street to get back down to business – making its routinely obscene profits and pulling down its even-more-stunning year-end bonuses. After all, modern financial reporting techniques forced banks to write their securities portfolios to market price, so if the market dropped the loss amounts should be clear. Furthermore, the new lower market price should reflect all the additional risks that had been uncovered, so there should be no reason to expect additional bad news.

Case closed. Right?

Not necessarily.

For small players, this is correct. Japan’s Nomura Securities Inc. (NMR) exited the U.S. mortgage business altogether, reducing its exposure from $2.4 billion (266 billion yen) in June to $120 million (14 billion yen) in mid-October, of which only $1 million is still related to subprime mortgages.

By writing off $610 million (73 billion yen), and recording a third-quarter loss, Nomura put its U.S. mortgage woes behind it, and can now focus on its very attractive core business of being the largest investment bank in the world’s second-largest market – the rapidly expanding economy of Japan.

For larger players, the solution isn’t quite so clear. For one thing, they can’t maneuver as quickly as Nomura because the Big Boys still have large holdings of financial rubbish on their balance sheets. That’s not easy to purge.

Starting Nov. 15, we will have a new arrow in our quiver to help us divine just how financial toxic waste a company is holding. The new accounting rule, Financial Accounting Statement 159 (SFAS 159), requires banks to divide their tradable assets into three "levels," according to how easy it is to get a market price for them.  Level 1 assets have quoted prices in active markets. At the other extreme are Level 3 assets, which have only unobservable inputs to measure value, meaning they must be valued by the bank’s own proprietary models.  

The problem with Level 3 asset pricing is quite obvious. Who writes the models that are used to value the assets: Bank employees, of course, the same bozos that get paid huge profits if the bank’s quarterly profits rise.  In the old days, assets were recorded on the books at historical cost, and their value was only changed if something bad happened, in which case the values were either written down or written off.

In today’s fine world, the values can actually be written up if their "market value" increases, even though that market value is determined only from a model that bonus-receiving employees have designed. In a bull market, of course, when assets generally go up in value, and there’s lots of money sloshing around, optimism naturally takes over and reported book values soar. In a down market, however, a bank with lots of Level 3 assets will give its shareholders a series of nasty surprises, or – in extreme cases – go bust.

Goldman’s Conundrum

I hate to depress you further about our finest financial brains, but this isn’t a small problem. Wall Street doesn’t have to report these numbers until its fiscal years starting after Nov. 15; so few banks have yet disclosed the amount of Level 3 assets in their balance sheet.

I would think they would be forced to do so in their first quarter results, typically the period that ends either Feb. 28 or March 31. However, Goldman Sachs, in the midst of preening itself about its remarkable write-off-free third quarter, disclosed its Level 3 assets: $72 billion. True that’s only 8% of Goldman’s assets. But it is twice the investment bank’s total capital of $36 billion.

Do you see where I’m headed with this? Not all Goldman Sachs’ Level 3 assets are subprime mortgages, of course. But not all Nomura’s mortgage assets were subprime mortgages, either. In fact, it was only 27%. Yet Nomura, to exit the business, wrote off 28% of mortgage assets, more than its entire subprime exposure. If Goldman Sachs is forced into pessimism, it too may have to write off 28% of the value of Level 3 assets, or even more. That would give Goldman a write-off of slightly more than $20 billion – or more than half its capital. Of course the Fed and all the other big banks would rally ‘round – to avoid a banking-system collapse – meaning Goldman would probably survive. But you wouldn’t want to be a shareholder.

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As other banking firms disclose their Level 3 assets, compare the total to the bank’s asset figures. Banks with Level 3 assets that are 50% of capital and lower are probably sound. Any higher and it’s probably time to sell. [At Goldman, Level 3 assets are 200% of capital].

Let Wall Street have its fantasies of wealth and sudden unexplained collapses, and put your money in markets and in businesses that don’t have the right to "invent" values for their asset portfolios. That’s true of the emerging markets, for instance, and especially those developing economies that are growing rapidly and that are highly liquid such as Korea and Taiwan, just to name a few. And in terms of developed markets that share the same fine financial characteristics, consider Nomura’s home market of Japan.

Profit Plays to Make

Indeed, if you want to be invested in financial services – and you should be – give Nomura a close look. Look also at Korea’s largest financial institution, Kookmin Bank (KB), which trades on the New York Stock Exchange as an American Depository Receipt (ADR). If you aren’t so keen on financial services, but want to benefit from economic growth that’s relatively untouched by Wall Street’s machinations, consider an exchange-traded fund (ETF), or a similar index fund for an economy that specializes more in high-tech than finance, such as the iShares MSCI Taiwan index (EWT).

The Taiwan economy includes such emerging high-tech stalwarts as Acer Inc., which just passed the Lenovo Group Ltd. (LNVGY) to become the world’s No. 3 personal computer vendor. It is also home to Hon Hai Precision Industry Co. Ltd., the world’s No. 1 contract-manufacturer of consumer-electronics products, and the company that makes the Apple Inc. iPhone (AAPL), motherboards for Intel Corp. (INTC), and all three of the rivalling computer gaming systems now duking it out in the world markets. Business Week has labelled Hon Hai as an "earnings machine." But because of restrictive Securities and Exchange Commission rules, the only way U.S. investors can buy into Hon Hai is through such vehicles as this ETF.

Not a bad move. You access greater growth than in the slumping U.S. market, earning profits from faster-growing companies. You’ll sleep better. And your early morning breakfast or daily stop at Starbucks won’t be ruined after you read of some new, and wholly unexpected write-offs in banks in which you’re a shareholder.

News and Related Story Links:

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Just one day after Merrill Lynch & Co. Inc. (MER) wrote off billions in bad mortgage loans and reported its biggest quarterly loss in 93 years, Wall Street analysts yesterday (Thursday) predicted there was still more bad news to come.

Although it wrote off $8.4 billion of subprime mortgages and others debts in the third quarter, experts say Merrill failed to accurately predict the size of its quarterly loss and also didn’t outline how it has reduced its overall debt exposure. The upshot: The company has lost a lot of credibility on Wall Street and analysts now fear it may be looking at $4 billion in additional write-offs in the fourth quarter, according to Forbes.com.
Merrill’s shares dropped as much as 7% yesterday, finally closing at $60.90, down $2.32 a share, or 3.67%.

But most importantly for investors, the revelations of the past two days served as sobering reminders that the subprime-mortgage debacle has a long and miserable tail. 

Two of the world’s biggest banks, Citigroup Inc. (C) and UBS AG (UBS), announced multibillion-dollar third-quarter writedowns three weeks ago, and their stock prices actually jumped.  After announcing a $5.9 billion writedown, Citigroup’s stock gained 2%.  Likewise, UBS climbed 3.2% after announcing its $3.4 billion. The reason: Analysts believed the write-offs defined the extent of the mortgage mess, meaning the end was in sight.

"These writedowns just lulled the market into a false sense of security, that the subprime problem had been defined and written off and we could all move on. However, it wasn’t as simple as that," says Martin Hutchinson, our Money Morning banking and financial expert.

But Money Morning predicted there was more pain to come.

Merrill Lynch is now a case in point. The investment bank’s $8.4 billion hit nearly doubled the firm’s prediction of three weeks ago. The writedowns on subprime mortgages, asset-backed bonds and leveraged loans combined to generate a third quarter loss of $2.24 billion, six times the company’s initial estimate. 

What’s astonishing isn’t just the magnitude of the writedowns and the dent in quarterly profits, but Merrill’s inability to anticipate the losses.

Dick Bove, bank analyst at Punk Ziegel, was one of the first to point out that the fat lady hadn’t quite sung for the subprime mortgage meltdown. In an interview with USA Today, he alluded to the 1987 credit crisis and pointed out that the Federal Reserve wasn’t able to fix that problem with rate cuts. It took several years for that debt crisis to work its way through the system.

In 1987, Citigroup’s then-CEO John Reed also announced a major charge against earnings – a $1 billion write-off related to problems with loans to Latin America.

"John Reed said exactly what [current Citigroup CEO] Chuck Prince said," according to Bove. "We’ve figured out the problem, isolated it and eliminated it. Stocks went up, and everybody was happy. However, we know from hindsight that in 1991, Citi was still writing off its Latin American debt because they hadn’t isolated the problem and they had no idea what the depth of the problem was."

Bove recently took the unusual step of cutting his rating on Citigroup to "Sell" from "Market Perform," and lowered his price target to $43 from the prior target of $53. Wall Street analysts rarely rate a stock as an outright "Sell," instead using such well-understood code words as "Hold." By listing Citi’s shares as a "Sell," Bove made clear his disenchantment with the company’s performance.
Just a few weeks ago, industry executives warned that the housing market might not recover until 2010.

"It’s going to be a long time before we see [the housing market] bottom out and recover," David Lowman, chief executive of JPMorgan Chase & Co. (JPM) said at the Mortgage Banker’s Association’s annual convention. 

And here are a few more facts to consider:

• In the next few years, more than 75% of the nation’s housing markets will suffer an overall price decline – some by double-digit amounts.
• A few weeks ago, Peter Orszag, director of the Congressional Budget Office (CBO), told a Senate panel that if home prices drop as much as experts have projected, U.S. households could lose $3 trillion in wealth.

• Adjustable-rate mortgages to subprime borrowers accounted for 7.3% of all home loans and 44% of all new foreclosures, according to the Mortgage Bankers Association. An estimated 2 million to 2.5 million adjustable-rate mortgages (ARMs) are scheduled to reset this year and next, jumping from low "teaser" rates to much steeper rates that in some cases could cost borrowers their homes.

Merrill Lynch just paid a heavy price for underestimating the extent of the subprime crisis. Don’t be fooled into thinking the worst is over, there could be plenty more fallout on the way.

News and Related Story Links:

• Money Morning:
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• Money Morning:
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• Forbes.com:
  More Merrill Writedowns Expected.
  
• Money Morning:
  Dropping Housing Prices, Rising Foreclosures Could Confirm Our Worst Fears.

• Money Morning:
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• Money Morning:
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• Bloomberg:
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Housing prices will continue to decline and the downward spiral may not end until sometime in 2010, industry executives said this week.

Speaking at the Mortgage Banker’s Association’s annual convention Monday, executives from Fannie Mae and Freddie Mac, as well as the CEOs of two other major mortgage banks, said U.S. housing prices would continue to decline throughout next year, according to a report by The Associated Press. Indeed, several of America’s leading financial analysts presented a dour outlook for the U.S. housing market at the convention, and few of the executives had anything positive to add.

David Lowman chief executive of J.P. Morgan Chase & Co. (JPM), Paul Bibb CEO of National City Mortgage (NCC), and Thomas Lund and Patricia Cook of Fannie Mae (FNM) and Freddie Mac (FRE) held a round table discussion attended by most of the convention’s 4,000 participants. The consensus seemed to be that the recent spike in foreclosures and saturation of unsold homes would leave the housing market reeling for the next two years. 

 "It’s going to be a long time before we see [the housing market] bottom out and recover," said David Lowman, "There’s too much inventory in the marketplace." Lowman also said the price decline may not end until 2010.

Thomas Lund painted a slightly more upbeat picture, saying prices would flatten out in 2009 – before gradually rising. Lund added that he believed "this year we will see a 2% decline in national home prices, and we’re projecting about a 4% decline next year."

Patricia Cook, chief business officer at Freddie Mac, said that investors would need to see a slowing in the rate of foreclosures before regaining confidence in the mortgage-backed securities market. That revival isn’t expected to occur anytime soon, as many adjustable rate mortgages will be resetting over the next year. The Federal Deposit Insurance Corp.  (FDIC) estimates that 2.5 million mortgages made to borrowers with poor credit will reset at sharply higher rates by the end of 2008.

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Both Cook and Lund have lobbied Congress to infuse more cash into the market and provide lenders with the leeway to help homeowners refinance. Some lawmakers have joined them in urging regulators to let Fannie Mae and Freddie Mac (two government sponsored institutions) increase their holdings of mortgage debt by 10%.  The current limit stands at $735 billion.

According to Lund, higher investment caps, even temporary, would help restore investor confidence.

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• Money Morning Investment Analysis:
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Stocks tumbled yesterday (Monday) as oil prices soared and three major U.S. banks announced a plan to revive the asset-backed commercial paper market.

The Dow Jones Industrial Average fell 108.20 points, or 0.77%, to close at 13,984.80. The broader Standard & Poor’s 500 Index closed at 1,548.71, down 13.09 points, or 0.84%. The tech-laden Nasdaq Composite Index fell 25.63 points, or 0.91%, to close at 2,780.05.

The market sag came amid news that three major U.S. banks would combine forces in an effort to resurrect an asset-backed commercial paper market deeply wounded by the housing slump and subsequent credit crunch.

Also dragging on the market were concerns over rising energy costs as colder weather sets in.  Oil prices cracked $86 a barrel Monday, closing at $86.13, a jump of $2.44 a barrel, or nearly 3%.

Oil prices rose above an overnight record close in Asian trading today (Tuesday) to set a new high after the Turkish government yesterday (Monday) asked its parliament for permission to pursue Kurdish rebels into Iraq – stoking fears that oil supplies in the region will be disrupted.

Light, sweet crude for November delivery rose 51 cents a barrel to reach $86.64 in electronic trading on the New York Mercantile Exchange by mid-afternoon in Singapore. Indeed, prices rose by as much as 66 cents a barrel in the electronic session to a fresh trading high of $86.79 a barrel.

Oil prices of $86 a barrel or greater are at a "historically high level… Many people are looking at this level for the first time so it’s very difficult to say what will happen next," Tetsu Emori, a commodity markets fund manager at ASTMAX Futures Co., in Tokyo, told The Associated Press. "All the factors in the market are bullish, there are no bearish factors except maybe that the market looks like it’s been overbought, technically."
Despite the gains, oil is still below inflation-adjusted highs hit in early 1980. Depending on the adjustment, a $38 barrel of oil in 1980 would be worth $96 to $101 or more today.

Yesterday’s record oil-price surge stemmed from some troubling reports from both the International Energy Association (IEA) and the Organizations of Petroleum Exporting Countries (OPEC).

OPEC said in a report yesterday that it’s likely the rest of the world will produce 110,000 fewer barrels of oil per day in the fourth quarter than previously expected. It also said that at the same time, demand would grow by 100,000 barrels per day over last year. 

Last week, the Energy Department reported that domestic crude inventories fell during the week of October 5, when they were supposed to increase.  Also in a separate report, the IEA said that oil inventories held by the world’s largest industrialized is below its five-year average. 

Additionally, speculation that Turkey could enter Iraq in response to attacks by Kurdish rebels has given investors even more cause for concern. 

"Oil out of northern Iraq fields has been erratic for some time," Linda Rafield told CNN, "But complete disruption would definitely be bullish for this market."

Investors were troubled by a debt deal by three major banks. Citigroup Inc. (C), Bank of America Corp. (BAC), and J.P. Morgan Chase & Co. (JPM) said yesterday that they would buy assets from structured investment vehicles (SIVs) to prevent investors from dumping their holdings. SIVs are typically bank-run, programs de­signed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments such as bank bonds or subprime mortgage debt. 

The fund, known as the master liquidity enhancement conduit, or M-LEC, will finance the purchase of assets by selling medium-term notes and commercial paper to investors, the banks said in a joint statement.  Sources familiar with the agreement told Bloomberg News the fund would be worth approximately $80 billion.  The fund is expected to be fully established within the next 90 days.

The commercial paper market suffered mightily in July and August as the subprime meltdown forced investors to retreat. The amount of asset-backed commercial paper outstanding plummeted from a high of $1.14 trillion at the end of June, to $899 billion in the week ended October 10. 

Treasury Secretary Harry Paulson mediated the agreement after a commercial paper market shutdown forced the sale of about $75 billion in assets.  Alex Roever a debt strategist at JPMorgan told Bloomberg SIVs have at least $32 billion in assets.

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• Bloomberg:
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• CNN:
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• The Associated Press:
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Three of the United States’ biggest banks – Citigroup Inc. (C), Bank of America Corp. (BAC) and J.P. Morgan Chase & Co. (JPM)- announced yesterday (Monday) that they agreed to start a fund to enhance the liquidity of asset backed commercial paper (ABCP) and medium-term notes by structured investment vehicles (SIVs).

The new fund – technically known as a "master liquidity enhancement conduit," or M-LEC – will purchase highly rated assets from existing SIVs that choose to take advantage of this source of liquidity. The banks said they are still determining the capital structure, underlying cushion and size of the fund, though Bloomberg reported that insiders say it is about $80 billion.

"Access to such liquidity is intended to allow participating sellers to meet pending redemptions and facilitate asset-backed commercial paper rollovers," the banks said in a statement.

The fund could be up and running within 90 days, and other banks and investment management firms have expressed support for the plan, the banks report. [For a full analysis of the long-term impact this fund is expected to have, as well as a recommendation on the single stock to buy in order to profit, please click here.]

"Recently, refinancing in the asset-backed commercial paper markets has been difficult despite the high-quality collateral underlying many of these securities. The objective of M-LEC is to facilitate these re-financings and to complement other market-based solutions in supporting an orderly and efficient market environment," the statement said.

Bloomberg quoted U.S. Treasury Secretary Henry Paulson praising the plan, saying it will help shore up the U.S. economy. 

"In the shorter term, I applaud a private-sector initiative to speed up liquidity in the asset-backed paper market," Paulson said. "That can only be good for the capital markets, that can only be good for what’s going on in the mortgage markets today, and can only be helpful to the economy if this works as the people leading this hope it will work."

However, Wall Street didn’t respond so kindly, as the fund’s announcement was partly blamed for the Dow Jones’ drop of more than 100 points. And it didn’t help the one of the three backing companies, Citigroup, announced yesterday that third-quarter profits fell 57%.

News and Related Story Links:

• Bloomberg News:
  Citigroup, Bank of America Plan $80 Billion SIV Fund.

• Yahoo Finance:
  Stocks Retreat Amid Bad Debt Worries.

• CNNMoney.com:
  Citigroup posts 57 percent drop in 3Q.

Invest in the homebuilding sector at your own risk.

U.S. homebuilders such as D.R. Horton Inc. (DRI), KB Homes (KB) and Pulte Homes Inc. (PHM) capped the sector’s biggest two-day advance since August yesterday (Tuesday), thanks to a growing investor belief that the worst of the subprime-mortgage crisis has passed. On Monday – a day in which banking giants Citigroup Inc. (C) and UBS AG (UBS) released horrid third-quarter results – the Dow Jones Industrial Average surged to an all-time record above the 14,000 mark, ostensibly because investors believed the subprime mess and the accompanying global credit crisis was at least now largely defined.

But don’t you believe it.

Peter Bookvar, equity strategist at Miller Tabak, is thinking along similar lines.

"You don’t have a multi-year credit bubble that is over in a couple of months," Bookvar told MarketWatch.com yesterday. "Why the market thinks that is beyond me."

Market trading in the housing-and-finance-related sectors will prove us correct in the days and weeks to come.

The Fed-Fueled Crisis

This whole subprime mortgage crisis – as well as the global credit crunch that grew out of it – is part of a financial bubble or speculative mania, not unlike the "dot-bomb" crisis that derailed high-tech stocks back in 2000. Both of these bubbles grew out of the overly open monetary policies of the U.S. Federal Reserve, the same Fed that just cut interest rates by a greater-than-expected half a percentage point back on Sept. 18.

Right up to the eve of that policymaking Federal Open Market Committee (FOMC) meeting last month, Contrarian investors such as Jim Rogers were arguing that the central bank shouldn’t be cutting interest rates, but should actually be raising the benchmark Federal Funds Rate. I wasn’t quite so contrary: However, I did argue that the Fed should hold the line on interest rates, and that it shouldn’t be looking to bail out the hedge-fund and investment-bank speculators who knew what the risks were. Nor should it be helping to bail out mid-level European lenders who had absolutely no business speculating in subprime mortgages. I mean, why a German or French bank would want to invest in the debt that consumers with lousy credit were using to buy homes in marginally justifiable transactions – and in the United States, no less – is beyond me. They deserve what they got, and don’t rate a bailout.

But they got one, and that’s only going to prolong the pain U.S. investors are going to experience.

If you don’t believe me, just look at some past bubbles.

Bubbles, Bubbles, Toil and Troubles

During the big Internet frenzy, telecom companies (as well as many wannabes from other sectors) searched for ways to capitalize on this new medium for the masses. Scores of companies built high-speed communications networks, burying fiber-optic cable faster than Johnny Appleseed planted Golden Delicious apple trees. But the analogy is perhaps fitting, since most of those greed-fueled companies ended up eating their fiber-optic networks. Indeed, when the dot-com bubble burst and the end came, Merrill Lynch estimated that of the millions of miles of fiber-optic networks that had been built, 97.5% was "dark," or superfluous.

Thankfully, in the seven years since, such innovations as video-on-demand, streaming media, Internet Telephony, videoconferencing, and countless other inventions have helped the new landlords of those networks recoup their "pennies-on-the-dollar" purchase prices.

But tech-stock investors – especially those who were late to the party in the latter half of 1999 and the first few months of 2000 – haven’t been so fortunate.

The bellwether index of that period was the Nasdaq Composite Index, which peaked in March 2000 at 5,048.62. It’s not been back since, and won’t reach that peak far above us for years – and maybe not for decades.

[At yesterday's close of 2,747.11, the Nasdaq is down about 2,300 points - or 46% - from its all-time high. For comparison, consider the Great Crash of 1929, and the Great Depression that followed. In researching our book, Contrarian Investing, my co-author and I found that the Dow fell from a high of 381 on Sept. 3, 1929 to a July 1932 trough of 41 - a sickening decline of 89%. The Dow didn't eclipse its 1929 high again for good until November 1954 - nearly a full 25 years later. The situation here isn't nearly so dire. But this example demonstrates just how deeply a financial crisis can wound an economy.]

I’ve done a lot of research on speculative bubbles and financial manias, and I’ve found one thing to be true time and again through history. Whenever there is a speculative mania, it’s never confined to one asset class. A bubble owes its very life to the fact that it’s being fueled by cheap money or easy credit. And, as the bubble inflates, it creates more of the same. Soon there’s all this easy money sloshing about in the economy. Basic physics holds that water will find the easiest route to travel, and as the level of easy money rises, it overflows the confining banks of the conventional economy, and starts fueling bubbles in other areas – just as the tech-stock bubble of 1999-2000 helped fire off the housing bubble we’re suffering through today.

And the fallout from that bubble won’t just go away because the Fed cut interest rates once, or even twice, or because the chief executive officer of Citigroup says the banks disappointing third quarter has allowed the company to better visualize the better days to come. Here’s why.

Citigroup and the Two Views of ‘Normal.’

This is actually a two-part problem, right now: The housing market is in deep trouble – still – and the financial markets still haven’t fully factored in the problems that are still to come.

The reason investors sent homebuilding stocks on their two-day jaunt was – at least initially – fueled by a ratings upgrade by an analyst at (of all places) Citigroup, the banking heavyweight that on Monday announced that big writedowns would cause the third-quarter profits at the No. 1 U.S. bank to plunge by 60%.

The banking giant attributed the $1.4 billion pretax writeoff to lousy mortgage investments, deteriorations in the consumer-credit markets, and debt it got stuck with because of some corporate buyout deals that went bad.

Some Wall Streeters were calling for the head of Citigroup Chairman and CEO
Charles Prince. But yesterday, Citi’s "other" prince – Saudi Prince Alwaleed bin Talal Alsaud, the bank’s single-biggest investor – said he was backing the current management team, even with the third-quarter "hiccup."

Even so, top Wall Street banking analyst Richard X. Bove said investors misunderstood what the Citigroup CEO meant with his reference to a "return to a normal earnings environment this quarter." If Bove is correct, the outlook is much more dour than investors currently believe.

Investors thought Prince meant that Citi would return to the level of profitability they were anticipating before the subprime mortgage problem surfaced, Punk Zeigel’s Bove wrote in a note to clients. But what Prince really meant was that Citigroup and its peers are merely on a track to normal profitability, Bove wrote.

Bove took the unusual step of cutting his rating on Citigroup to "Sell" from "Market Perform," and lowered his price target to $43 from the prior target of $53, The Associated Press reported.

Then there’s the housing market…

Housing Bubble is Double Trouble

When I heard that homebuilder stocks were rallying, I first thought back to the fiber-optic debacle of 1999-2000. This isn’t exactly the same situation, since it’s not so much an overbuilding boom that we’re looking at here. But it is an "over-selling" boom. Overly low interest rates created overly accessible credit.

With interest rates at abnormally low levels thanks to the rate-cutting campaign former Fed Chairman Alan Greenspan engineered to short-circuit the Asian contagion and the implosion of the Long-Term Capital Management hedge fund (see all the trouble those hedge-fund bailouts can cause?), consumers with solid credit were able to qualify for and then buy a much-larger and much-more-expensive house than they could have afforded during more normalized periods.

Then there were the consumers with poor, or undocumented, credit ratings, which fueled the subprime-mortgage market.

In short, while we didn’t build too many houses during this bubble, we probably sold too many. Many deals just shouldn’t have been made.

And while experts claim they suddenly have a handle on how much subprime debt is out in the market – a contention I have a tough time believing – that’s far from being the only problem. Consumers who "stretched" a bit to buy a house on credit, or to buy a bigger house than they could afford, often resorted to "adjustable-rate mortgages, or ARMs. But these ARMs have an added, troublesome feature, a trigger known as "resets." The premise of a reset is simple: As interest rates rise, high-credit-risk borrowers with adjustable-rate mortgages are going to get clobbered.

Over the next few months, more than 2 million homeowners with subprime ARMs are looking at resets – and at much-higher interest rates – a reality that’s likely to deepen and lengthen an already-dismal housing downturn.

More than $50 billion in ARM loans will reset this month alone, a record for a single month, says Economy.com, an econometric firm based in West Chester, Penna.

Even the near-term numbers don’t look that good: Just yesterday (Tuesday), the National Association of Realtors reported that that the pending home sales index fell 6.5% in August after dropping a revised 10.7% in July. The index – a forward-looking gauge of home sales – is at its lowest point since it was created in 2001.
[For our full report on this story, please click here].

Pending home sales are down 21.5% from a year ago and 22% from six months ago, according to MarketWatch.com. Even worse: Economists had been expecting the index to drop only 2.5%.

"This is absolutely awful, confirming that the existing-homes market is now in a freefall,” Ian Shepherdson, chief U.S. economist for High Frequency Economics, wrote in a research report.

Go Global and Profit

If the U.S. housing market is going to continue to erode, so is consumer spending, which accounts for as much as 70% of all U.S. economic activity. Over the past decade, U.S. consumers have repeatedly reduced their savings from their wages until that ratio has actually turned negative. But consumers could spend more than they earned because their savings was being done for them – first by the stock market, and then by the real estate market. Indeed, some economists charge that consumers were using their homes as "virtual ATM machines," extracting cash for cars, vacations, home improvements, and other non-necessities. That’s helped fuel the U.S. economic advance of the past decade or more.

But if housing prices are skidding backward, that’s going to put a crimp in consumer spending. And that’s going to cause new homebuilding – and the overall economy – to slow dramatically for at least the next couple of years.
Some perennially bearish investors are speaking of an even worse scenario. In a recent interview with Bloomberg TV, noted short-seller David W. Tice says that this financial mess could lead to a 40% drop in the value of the Standard & Poor’s 500 Index sometime in the next 12 months. We doubt it will be that bad, but would still preach caution.

One other troublesome point that no one here in the U.S. financial markets seems to be talking about: The real estate market in Great Britain has been white hot, and is eerily reminiscent of the path the U.S. real estate market took right up until the housing market here crashed. Some experts – at least, those overseas – wonder if Great Britain isn’t going to be another United States, perhaps delayed by six months, eight months, or even a year.

It makes me wonder what kind of "subprime surprise" we’ll find was fuel of Great Britain’s housing bubble, and subsequent collapse.

It’s worth watching.

Investors who turn their attentions toward profit opportunities in the right markets overseas, as we have been advocating for some time, won’t see a decline in their investment returns [If you aren't a Money Morning subscriber, please click here to receive our 6,000 word investment report: The Three Best Investments in Asia Today. It's free of charge.]

But those who continue to play "yesterday’s investments" in the U.S. market run the very real risk of being left behind financially.

And none of us wants that to happen.

News and Related Story Links:

• Contrarian Investing, by Anthony M. Gallea and William Patalon III.
• Bloomberg News:
  Alwaleed Backs Citigroup Chief After Profit ‘Hiccup.’

• Money Morning Investment Analysis:
  The Three Simple Secrets to Global Investing Profits.

• Bloomberg News:
  Most U.S. Stocks Advance; Financial Shares, D.R. Horton Climb.

• Money Morning News:
  Citigroup and UBS Brace For Losses, but Dow Jones Sets Record Above 14,000.

• BusinessWeek:
  Analyst Actions: Homebuilders, Mothers Work, Hologic, Kellwood.

• Money Morning Investment Analysis:
  Sen. Dirksen: Allow Me to Introduce You to Standard & Poor’s.

• CNNMoney.com:
  Mortgage Resets: Record Bill Coming Due.

• CNNMoney.com:
  Q4 on Wall Street: Bad News is Good News on Wall Street.

• CNNMoney.com:
  Trouble Ahead for the Fed.

• CNNMoney.com:
  Pending Home Sales at Record Low.

• Money Morning News:
  U.S. Economy Surges in the Second Quarter, Struggles After That.

• Money Morning News:
  Housing Sales and Prices Drop As Consumer Confidence Retreats.

• CNNMoney.com:
  Big Write-Downs to Slash Citi’s Quarterly Net 60%.

• Money Morning Investment Analysis:
  Where Are All the Subprime Bodies Buried?

• Bloomberg News:
  U.S. Stocks Rally, Sending Dow Average to Record; Lennar Gains.

• MarketWatch.com:
  Pending home sales down 6.5% in August: report.

• MarketWatch.com:
  Wall Street Steps Back From Prior-Session Rally.

• The Associated Press:
  Ahead of the Bell: Citigroup.

• Money Morning Investment Analysis:
  Jim Rogers Warns of Fallout From Fed Cuts; Says to Seek Profits in Commodities, Asian Currencies.

• Money Morning News Analysis:
  Fed’s Bernanke is Pushing the Right Buttons.

• Money Morning News Analysis:
  Europeans Won’t Euthanize Corporate Stupidity.
• Bloomberg News:
  Japanese Shares Advance, Led by Nomura, JFE; Toyota Slides.

• Wikipedia:
  Long-Term Capital Management.

• Wikipedia:
  Contrarian Investing.

• Finfacts Ireland: Fifth Anniversary:
  Nasdaq’s Record All-Time Closing High 5,048.62.

On a day that two huge banks took major profit hits because of the subprime market crisis, stocks soared to record highs yesterday (Monday) on the belief that the worst of the ensuing credit crisis had passed.

Citigroup (C) and UBS AG (UBS), the largest banks in the United States and Europe, said yesterday that their third quarter earnings would reflect the heavy toll taken by the collapse of the U.S. subprime market. Citigroup thinks its earnings will drop 60%, while UBS anticipates losing as much as $690 million in the third quarter.

Citi’s shares jumped $1.05 each, or 2.3%, to close at $47.72, while UBS, the largest Swiss Bank, soared $1.69 per share, or 3.2%, to close at $54.94, as investors put credit conditions behind them and sent the Dow rocketing to a new all-time record close.

The Dow rose 191.92, or 1.38%, to close at 14,087.55, surpassing its closing record of 14,000.41 set in mid-July. The blue-chip bellwether index rose as high as 14,115.51 to eclipse its previous intraday high of 14,021.95, set July 17.

It was the first day of trading in the new quarter. During the third quarter, a volatile Dow still managed to post a 3.6% gain.

Stocks advanced broadly yesterday. The Standard & Poor’s 500 Index rose 20.29 points, or 1.33%, to close at 1,547.04. That’s close to its all-time trading high of 1,555.90, which was established in the middle of July.

The tech-laden Nasdaq Composite Index jumped 39.49 points, or 1.46%, to close at 2,740.99.

The Nasdaq is nowhere near its all-time high of 5,048.62, reached in March 2000, in the middle of the dot-com bubble.

Citigroup said it would write down approximately $1.4 billion on loan commitments and record $1.3 billion in losses related to the subprime mortgage market. The company will release its third quarter results on Oct. 15.

UBS will write down $3.42 billion in mortgaged backed securities. The company will also cut 1,500 jobs, or about 2% of its workforce. The company’s management will see some changes as well. Chief Executive Marcel Rohner will take over as Investment Banking Chief, replacing Huw Jenkins, who will be relegated to an advisory position. Group Chief Financial Officer Clive Standish will retire. Rohner replaced Peter Wuffli as Chief Executive in July.

The subprime collapse and credit conditions have had an adverse effect on the buyout market as well. Because of the higher perceived risk, the debt required to finance acquisitions is now more expensive, meaning that deals struck at the height of the private equity boom have lost their original luster and are being abandoned.

Silver Lake and ValueAct Capital called off the $2.2 billion buyout of Acxiom (ACXM).

The $25 billion buyout of Sallie Mae and $8 billion deal for Harman International Industries are also in jeopardy. The current backlog of pending U.S. buyouts stands at approximately $400 billion. That means that more stalled buyouts may well loom.
However, further fueling the general feeling that the credit crunch is ending, Homebuilding stocks roared after several of the largest players were upgraded by Citicorp. A report by the bank’s brokerage arm said that large-cap builders with stronger balance sheets should benefit in the coming quarters.
Lennar Corp. (LEN) rose 62 cents, or 2.7%, to $23.27; D.R. Horton Inc. (DHI) added 65 cents, or 5.1%, to $13.46; and Pulte Homes Inc. (PHM) was up $1.18, or 8.7%, at $14.79.

News and Related Story Links:

• The Associated Press:
  Dow Jones Passes 14,000 for Record High.

From Staff Reports

Australia’s ongoing economic boom – fueled by the continued growth in the Asia-Pacific Region – has left Aussie families less leery of debt, and more vulnerable to an economic shock or recession, Reserve Bank Deputy Governor Ric Battellino stated at a convention in Melbourne yesterday.

At a convention organized by the ‘Melbourne Centre for Financial Studies,’ Battellino said that Australian households were running a "highly mismatched balance sheet," consisting of property and shares on the asset side of the personal ledger, and a load of debt on the liability side. It’s the kind of highly leveraged mix that professional investors use to magnify returns on the upside – but which magnifies and acclerates losses on the downside.

"This balance sheet structure is very effective at generating wealth in good economic times," Battellino told the audience, according to a report by Australia’s Age.com newspaper. "But households need to recognise that it leaves them exposed to economic or financial shocks that cause asset values to fall and/or interest rates to rise."

But there’s also some good news. Unlike in the U.S. economy, where high debt levels are used to help fuel consumption, the rise in debt in Australia is being taken up by mostly higher-income households, and was used to buy such assets as homes, stocks, and investment properties. That means the debt is backed by assets, which can help diffuse any damage during a downturn, Battellino quite correctly observed.

"It would be a mistake, therefore, to conclude that a rising ratio of debt to income is necessarily a sign of financial stress," Battellino said.

But debt loads are worrisome when they climb. And in a sobering commentary, Battellino said there was absolutely "no precedent" in Australian history for the constant – and essentially vertical – growth in debt over the past four decades. In the mid-1960s, credit was only equal to about 25% of Australia’s gross domestic product. Today, that exceeds 150%.

News and Related Story Links:

• The Age.com News:
  High Debt Leaves Households Exposed: RBA.

• Speech by Australian Reserve Bank Deputy Governor Ric Battellino:
  ‘Some Observations on Financial Trends,’ Address to Finsia-Melbourne Centre for Financial Studies, 12th Banking and Finance Conference, Melbourne, Australia, Sept. 25, 2007.

• Money Morning News:
  Aussie Bank Chief Favors ‘Big Four’ Merger to Avoid Asia-Market Irrelevance.

When Federal Reserve policymakers announced the half-a-point cut in interest rates last Tuesday, I was almost at a loss for words.

As all of you know, I had projected reduction of 25 basis points, and by the time Tuesday’s meeting of the central bank’s Federal Open Market Committee (FOMC) rolled around, the market supported my view. Going into that FOMC meeting, the outlook was decidedly negative: The U.S. economy was slowing, and the lousy housing market was leading the downturn, and the global fixed-income markets are undergoing a painful restructuring. So far, everything was playing out according to our expectations.

But then the Fed surprised us with a mammoth injection of “monetary steroids.”

The central bank, seeking the Fed Holy Grail – a ‘soft landing’ – for the economy 9except for the housing sector), watched in recent months as the subprime-mortgage-induced housing problems spilled over into the fixed-income markets. Suddenly, what had started out as a domestic housing slump had turned into a global credit contagion.

While the ‘science’ of central banking includes many degrees of ‘art,’ the Fed found /itself in the difficult position of having to choose between two strategies, neither of the optimal. It could:

• It could cut interest rates – on the basis of one bad employment report and the possible widening of a global credit crunch – in anticipation of a possible economic slowdown.
• It could ‘stand pat’ and hold the line on interest rates – in the face of renewed inflationary expectations – as evidenced in the higher prices of gold, oil, wheat, and other commodities, as well as the low value of the U.S. dollar. But with the markets already having factored in a rate cut, the “stand pat” option was really no option at all. The reason: The moment the Fed said it was holding the line on short-term rates, the stock market would literally fall out of bed.

That meant that the central bank’s choice was a Hobson’s choice – for it was really no choice at all.

So the Fed opted to “protect” economic growth – and, in the process, mitigate the downturn in housing and the problems facing such highly leveraged players as financial institutions or hedge funds by dropping interest rates. It caught the entire market by surprise. This was much more than the market and I expected, and generated a rush out of cash and bonds. Why?

Very simple: A fear of re-acceleration in inflation. With a weak U.S. dollar and very strong global growth, the cuts add more fuel to the fire. And this will have a very beneficial effect on U.S. growth six to nine months down the line. While core inflation has recently been in a downward trend, the rise in the U.S. dollar-denominated commodities (oil, gold, other minerals and agricultural commodities) – together with the low value of the U.S. dollar – poses a major inflationary risk.

So, what’s your best defense in this situation?

• Go on the offense by taking advantage of the expected continued increase in commodities prices by purchasing commodities producers, such as major global mining companies.
• Buy into the more-promising emerging markets – such as Brazil – since they will be big exporters of these commodities. Also, many of these markets will benefit from major consumer booms as the economies evolve and develop.

The Fed acted boldly, and the markets responded likewise. We remain opportunistically bullish, with a preference for international and U.S. companies that will benefit from international growth.

Stay tuned for more action, probably as soon as next week.

Wall Street has firmly got it into its tiny overpaid noggin that the Fed Chairman Ben S. Bernanke and the central bank’s Federal Open Market Committee will slash interest rates today.

I’m not so sure.

Whatever Bernanke & Co. does will indicate the medium-term future of Federal Reserve policy and, more important to investors, will probably guide the future direction of the markets for the next year or so. So it’s worth looking at the possibilities, as this single decision will be the guiding light for your investment strategies for the months ahead. Even so, despite what you may be hearing, the results won’t be uniformly positive.

The Newest Speculative Mess

The crisis that has caused all the angst is a pretty simple one of a type that has recurred all too often through history. Credit became all too easy to get, meaning it became very easy for a bunch of guys who weren’t at all creditworthy to obtain money.

These non-creditworthy guys are most obvious in subprime mortgages, but there have been some overpriced leveraged buyouts done, which have left over $200 billion in potentially wobbly debt on banks’ balance sheets. In addition, I can’t believe subprime credit-card loans won’t soon be in just as much difficulty as subprime mortgages, because of more or less the same irresponsible lending. Finally, some of the more-marginal emerging markets, with too much debt, will descend into trouble if the world economy slows.

If you look back at every speculative crisis throughout history there’s always been some sort of new wrinkle that allowed the new generation of financial snake-oil salesman to sell the latest bill of goods to the newest group of soon-to-be shorn sheep.

This time around, the new "financial technology" is an ill-advised mixture of derivatives, asset-backed commercial paper, and securitization. This spread this glut of crummy debt all over the globe faster than SARS on a cut-rate airline…. now nobody knows where it all is. Brilliant! That’s why even interbank markets have seized up, with the international benchmark three-month London Interbank Offer Rate (LIBOR) trading far above the benchmark U.S. Federal Funds rate.

Rate Reduction Realities

If that financial history we referred to earlier is any indication, then it must be a law of financial physics that even when a financial innovation is a good thing in general – and figures to be a useful tool – it often seems to spawn an early crisis in which it is overused and creates a huge mess.

It follows that cutting the Federal Funds rate won’t do much.

It won’t restore confidence in the world’s banking system; that will take time, and good auditing, to find where the bodies are buried.

It won’t rescue the U.S. housing market: The subprime loans are getting "subber-prime" by the day, and an incremental cut in short-term rates won’t help them much.

Indeed, about all this rate cut will do is get Bernanke out of the firing line of angry Wall Streeters who are despairing over their 2007 bonuses, if you call that a good thing. And even there the rate cut will only be partially successful, as many of the folks on ‘The Street’ are predicting (or is that hoping for) a bigger rate reduction than the one Bernanke and the FOMC will probably order this afternoon.

Besides, the rate reduction is coming at a less-than-strategic moment, and will likely worsen inflation.

How to Play The FOMC Meeting

When you get right down to it, there are really three possibilities for tomorrow’s Fed policymaking meeting:

• First, the Fed could do nothing at all, holding the line on interest rates.
• Second, the central bank could cut the benchmark Fed Funds rate by a token quarter point, and accompany its announcement with a stern lecture on both speculation and inflation – capping it all off and punctuating its point in stunning fashion by adding a resolution that lets us all know that no more rate relief will be forthcoming [Note: With that stunning addendum, I guess this second possibility officially becomes possibility 2a.].
• Third, Bernanke gives in to Wall Street completely, slashes interest rates by half a point or even more, vows to bail out the debt market no matter what it takes, and sends both Larry Kudlow and Jim Cramer out on the town for a splurging celebration [perhaps having a bit of fun by charging the night's food and festivities on a subprime credit card].

Now, let’s consider the implications of each possibility.

Counting on a Cut: The immediate impact of no rate cut at all will be for the stock market to fall out of bed – starting so quickly after the 2:15 p.m. announcement that some Wall Street Wag will dub it the "mid-afternoon swoon." The reason: The stock market has been counting on a cut, not so much to bail out Wall Street as to stimulate economic activity and get corporate earnings moving again. In this case, the asset deflation will continue.

Your best bet will be to invest in places with high liquidity and little exposure to the U.S. debt markets – Japan, Korea, Taiwan and Singapore are the obvious places.

[If you aren't already a Money Morning subscriber, you really should sign up; doing so will provide you a copy of our free 6,000 word investment report: "Global Investing: The Three Best Investments in Asia." Having researched and written most of that report myself, I can attest to the fact that it's a very thorough look at the best places to invest in Asia, even during these uncertain times. Click here to see more].

The advantage of this "no-cut" strategy is that it gets the problem over with – immediately. Massive amounts of capital have been invested poorly, misdirected, or just plain frittered away; that needs to stop, and the bad investments need to be liquidated.

The U.S. economy would probably drop into a recession fairly quickly, and lots of workers would lose their jobs. But the downturn, though sharp, would probably be short-lived. Inflation would remain under control. And both oil and commodity prices – hotter than a meteorite in recent months – might be able to cool off and even decline somewhat in price, as the recession blunts U.S. demand.

Once the initial panic drop has happened, say in about 2 weeks, investors should look at something like the streetTracks SmallCap Japan ETF (JSC) which, consisting of smaller companies, is focused on the liquid, credit-crunch-free domestic Japanese market.

Fed surprises with a big cut: At the opposite extreme, if Team Bernanke cuts the Fed Funds rate by half a point – or even more – the U.S. stock market would rebound sharply, and might even soar. But that surprise rally won’t last for very long; reality will sink in as investors begin to realize that Bernanke hasn’t solved the pesky debt problem, and in fact may well have done some serious long-term damage to the U.S. economy – or, at least, caused damage that will take some time to repair.

Even so, the U.S. and other economies abroad will roll on down the highway, perhaps even accelerating a big, as renewed short-term confidence temporarily re-ignites the mergers market.

By my calculations, the "re-flationary" effect of a particularly sharp rate cut might last about a year, before soaring commodity prices and inflation generally cause a deeper recession and a worse long-term financial problems. If this happens, one investment will scream out: Gold.

In real terms, today’s equivalent of gold’s all-time high in 1980 is about $2,000 an ounce; gold closed last week at $709.60 an ounce. I’d bail out at around $1,500 just in case, but that would still give room for a doubling in price from today’s level.

[For another perspective on gold's potential upside, take a look at our recent investment analysis: "The Baywatch Effect: Can China's Growth Help Gold Prices Triple?"].

Probably the most efficient way to make this play is through the IShares Comex Gold Trust (IAU), which has $1 billion in capitalization and, thus, decent liquidity.

Needless to say, since the middle-course – the quarter-point rate cut and the stern lecture on the dangers of inflation and speculation – is the one that doesn’t really offer any very interesting investment recommendations, it’s probably the one Bernanke will choose.

The investment arena may well be the one place on earth where that bit of pop-culture advice courtesy of Meat Loaf ("Two Out of Three Ain’t Bad") just doesn’t ring true. And when translated into Japanese – as the cover of that hit single shows – the song title translates to: "66% Ain’t Bad."

Let’s hope the Fed’s action today isn’t equally as Lost in Translation.

Related News and Story Links:

• Wikipedia:
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• Wikipedia:
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  Market Bubble.
• Money Morning News:
  Bellwether Blue Chip Stocks Record Best Week Since April.
• Money Morning Investment Analysis:
  Defensive Investing is One Key to Profits in an Uncertain Market.
• Money Morning Investment Analysis:
  The ‘Baywatch Effect:’ Can China’s Growth Help Gold Prices Triple?
• Wikipedia:
  Two Out of Three Ain’t Bad.
• Wikipedia:
  Meat Loaf.