The Mortgage Bankers Association announced yesterday (Thursday) that home mortgage delinquencies reached the highest level since the survey began in 1985.

For the fourth quarter of 2007, 5.82% of outstanding home loans were in delinquency on a seasonally adjusted basis. This figure represents a 23 basis-point increase from the third quarter of 2007 and an 85 basis-point increase from the same period a year prior.

Another 2.04% of mortgages were in some stage of the foreclosure process with 0.85% of mortgages entering the foreclosure process in the fourth quarter. Both levels are also at record highs.

The survey looks at 46 million home loans on a quarterly basis, capturing data on roughly 80% of the home mortgage market.

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"Declining home prices are clearly the driving factor behind foreclosures, but the reasons and magnitude of the declines differ from state to state," Doug Duncan, MBA’s Chief Economist and Senior Vice President of Research and Business Development said in a statement. 

Duncan also addressed regions that represent a disproportionate percentage of home delinquencies.

"In states like Ohio and Michigan, declines in the demand for homes due to job losses and out-migration have left those looking to sell the homes with fewer potential buyers, particularly with the much tighter credit restrictions borrowers now face," Duncan said. "In states like California, Florida, Nevada and Arizona, overbuilding of new homes created a surplus that will take some time to work through."

The survey noted that 38% of delinquencies were come from prime loans, either adjustable-rate and fixed – a sign that the subprime crisis is spilling over into other sectors of the credit market.

"Of significance, however, is that the rate reset issue on adjustable rate mortgages is becoming less of an issue. The 6-month LIBOR rate, the index rate used for many subprime ARMs, has come down around 2.5 percentage points since last September, greatly reducing the payment shock on many ARM resets," Duncan said.

But many homeowners aren’t waiting for their adjustable-rate mortgage to reset before entering foreclosure.

"We’re seeing people give up even before they get to the reset because they couldn’t afford the home in the first place," Jay Brinkmann, vice president of research and economics for MBA, told Bloomberg News.

News and Related Story Links:

• Bloomberg:
  U.S. Mortgage Foreclosures Rise as Owners ‘Give Up’

• MarketWatch:
  U.S. foreclosures hit another record high, MBA says

• Mortgage Bankers Association:
  Delinquencies and Foreclosures Increase in Latest MBA National Delinquency Survey

An oversupply of homes, sharp rise in foreclosures, and stricter credit regulations caused home prices to fall 8.9% in 2007, the largest ever year-over-year decline in the S&P/Case-Shiller U.S. National Home Price Index.

Some metropolitan areas were whacked with double-digit devaluations. Home prices fell 17.5% in Miami, 15.3% in Las Vegas and Phoenix, 15% in San Diego, 13.7% in Los Angeles, 13.6% in Detroit, 13.3% in Tampa Bay and 10.8% in San Francisco. Worse, those were some of the hottest markets in 2006. 

Only three metropolitan areas saw prices increase for the year: Charlotte [2.3%], Portland [1.2%] and Seattle [0.5%].

"Wherever you look, things look bleak, with 17 of the 20 metro areas reporting annual declines and the remaining three reporting flat or moderate growth rates," Robert Shiller, chief economist at MacroMarkets LLC and co-developer of Standard and Poor’s S&P/Case-Shiller Home Price Indices, said in the statement.

The most striking statistic of the index is fourth-quarter declines. Prices in the fourth quarter decline 5.4%, following respective declines of 1.0%, 1.0% and 1.8% in the first, second and third quarters last year. 

Foreclosures up 57% in January… a good thing?

While Shiller and Co. didn’t give any predictions for first-quarter 2008, homeowners shouldn’t expect a drastic turnaround after last quarter’s massive declines.

However, a study by online foreclosure marketer, RealtyTrac shows the number of foreclosure filings in January signals that efforts by lenders and state and federal government are taking effect, said James Saccacio, RealtyTrac’s chief executive.

Foreclosure filings increased by 57% in January over the same month last year, and by 8% more than December 2007. In all, 233,001 were affected. Of that, 45,327 were repossessed. 

"January’s foreclosure numbers demonstrate that foreclosure activity is continuing on its upward trend, substantially increasing from a year ago in many states," Saccacio said in a statement. "However, the 8% monthly increase in January is not as precipitous as the 19% spike we saw in January of 2007, and several key states actually experienced decreasing foreclosure activity from the previous month."

"It could be that some of the efforts on the part of lenders and the government – both at the state and federal level – are beginning to take effect," Saccacio added. "The big question is whether those efforts are truly helping homeowners avoid foreclosure in the long term or if they are just temporarily forestalling the inevitable for many beleaguered borrowers."

News and Related Story Links:

• Standard & Poor’s:
  Year End Numbers Mark Widespread Declines According to the S&P/Case-Shiller Home Price Indices

• RealtyTrac:
  Foreclosure Activity Increase 8% in January

Despite a 1.25% reduction in the Federal Funds Rate last month, mortgage interest rates have not decreased according to a survey released today (Wednesday) from the Mortgage Bankers Association (MBA).

According to the MBA survey, interest rates for 30-year fixed-rate mortgages averaged 5.72% last week, up from 5.61% the week prior. Rates for 15-year fixed-rate mortgages also increased, averaging 5.18%, up from 5.09%. The increased cost of lending is making it harder to sell or refinance existing mortgages.

And homeowners aren’t the only ones feeling the pinch. Recent data compiled by Merrill Lynch & Co. (MER) indicates that businesses are also paying more for debt than they were prior to the Fed’s rate cuts.
"It’s the clogging up of the credit markets that worries me most," Harvard University economist Martin Feldstein said in an interview with Bloomberg News. "The Fed has done a lot of cutting, the question is whether it’s going to get the traction that it did in the past."

Amid concerns that bond insurers will lose their AAA-ratings and the possibility of more subprime-related asset write-downs, lenders are demanding a higher premium for the perceived increase in risk. This is bad news for Fed Chairman Ben S. Bernanke who is desperate to get consumers and business spending again to jumpstart a lagging U.S. economy.

"The problem is that every piece of news we’re getting continues to be bad," Stephen Cecchetti, a former New York Fed bank research director and now a professor at Brandeis University told Bloomberg. "They will have to ease more. It’s the only thing they can do."

Fed futures are pricing in a 100% chance of a 50 basis point reduction and a 20% chance of a 75 basis point cut at the Fed’s next meeting, which is scheduled for Mar. 18.

News and Related Story Links:

• MarketWatch:
  Mortgage applications down 2.1% last week: MBA

• Bloomberg:
  Fed Interest-Rate Cuts Fail to Lower Borrowing Costs

• Money Morning:
  Fed Comes Through with Expected 50 Basis Point Cut, But Markets Still Falter

Every bubble in history started with a good story. In the 1980s, it was the "Japan is better at everything" story. And in the 1990s it was the "new paradigm" story.

But as investors often find at great cost to themselves, a great story doesn’t necessarily make a great investment. In 1999, we were all convinced that the Internet would revolutionize the way we did business; that within five years we’d all be buying everything online and fax machines and letters would soon be made redundant by email.

We were, as it turned out, right. However, as it also turned out, that didn’t rationalize buying into firms such as Boo.com or Pets.com [neither of which ever made a penny before going bust] at the prices we did. Nor did it justify paying ridiculous sums even for a survivor such as Amazon.com Inc. (AMZN). The few years we thought it did represented the transformation of a good investment idea into a bubble. And when it ended, a lot of people lost a lot of money.

But the point investors should really take to heart is not the money lost in the carnage of the crash, but rather the money made before the crash. For example, if you’d bailed out of the market in 1996 – when Alan Greenspan first warned that tech stocks were overvalued  – you’d have missed out on four years of gains.

And even if you’d exited in, say, early 1999, you’d have missed Internet stocks jumping 61% in the fourth quarter of 1999 alone [the best gains of the entire tech boom]. The most money is always made at the very end of a bubble period.

So how do you know when a boom based on a good idea has turned into a bubble? And more importantly, how can you tell when that bubble is about to burst? This is the tricky bit. However, Robert Buckland and Orrin Sharp-Pierson of Citigroup Inc. (C) believe they may have found a few clues, if not the entire answer.

Basically, they suggest there are four stages to the credit/equity cycle. We’re now at stage three. This is the stage where – although the credit markets are running into trouble, the equity markets still have a lot of room for gains. But with valuations increasingly stretched and volatility rising, these gains are more likely to be bubble than boom gains.

Investable Bubbles

So where will these bubbles be? Happily, the answer, according to Buckland and Sharp-Pierson, is in areas where most MoneyWeek and Money Morning readers are likely to be heavily invested already – sectors exposed to the "global growth" trade. These are "the stocks or markets that are perceived to be most positively exposed to a robust global economy, irrespective of the U.S. slowdown" – basically, emerging market or commodity plays. If we accept that the key to a good bubble is a decent story, this makes sense, as we’ve told the story on these pages dozens of time.

It goes like this: The emerging markets – China and India, in particular – are reaping the benefits of globalization and industrializing. This is creating increasingly affluent and urbanized populations who want to improve their lifestyles fast. As their economies grow, they suck up raw materials from around the world, driving up commodity prices, and the share prices of companies with exposure to these markets.

The Asia story has been a solid investment theme for several years now – commodity stocks have made strong gains, while emerging markets in general have performed well. But the idea has only really taken off in the wider investor imagination in recent months. The market has started to worry about the state of the U.S. economy and investors have begun to see emerging markets as a safe haven to escape America’s credit-glut woes.

The result has been an extraordinary surge in a variety of stock markets. At one point recently, shares in Shanghai were up were 160% since the start of the year, while markets in Hong Kong, Vietnam, Pakistan and Indonesia were all up 40% or more. And that meant that a new "equity mania" focusing on these areas was possible, one in which people get carried away by the barrage of seemingly meaningful bits of business trivia [25% of the world's cranes are in China!] and use them to justify buying into expensive markets at any price.

While we’re comfortable with the idea that over the long run – by that, we mean 10 years, 15 years or longer – assuming nothing horrible happens, India and China will be great superpowers and probably great investments, too. But just because they will almost certainly keep growing, it doesn’t automatically make any sense for the Industrial and Commercial Bank of China to be the biggest bank in the world by market capitalization; or for insurer China Life Insurance Company Ltd. (LFC) to be more expensive than Warren Buffett’s investment vehicle, Berkshire Hathaway Inc. (BRK.A, BRK.B).

The analysts at Citigroup point to a few more signs of stocks being in bubble territory. At the time they wrote their report, China "A" shares were trading at a Price/Earnings ratio of 50, not far off the peak levels Japanese stocks hit in the crazy days of the late 1980, when alarmist books and movies such as Michael Crichton’s "Rising Sun," were meant to warn us how the Japanese Superman was poised to take over and dominate the world forever [which, itself, wasn't much before the heady bull market gave way to a 17-year bear market started....even so, the book remains a great read, and the flick is a favorite here at Money Morning].

And even our favorite emerging market, India, while not anywhere near the heady heights of China, was up 34% for the year at the time of the Citigroup study, meaning it wasn’t exactly cheap, either.

"India remains right now the only Asian economy driven primarily by domestic demand and not by exports. This means it is fundamentally less vulnerable to a U.S. economic slowdown than other Asian countries," said Christopher Wood of CLSA, a provider of brokerage and investment-banking services in the Asia-Pacific market.

So many people agree with him that, according to Mark Matthews and Willie Chan of Merrill Lynch & Co., Inc. (MER), Indian stocks were trading at a forward P/E of more than 20 times, compared with a 10-year average of 16. And Bloomberg has it trading at 25 times earnings.

When and When You Can Cash In

So what’s an investor to do? If you are going to buy into a new bubble, it might be best to do so via markets that have been lagging the big movers a little. We still like India, and there are several ETFs that give investors a good avenue. Barclay’s iPath MSCI India Index ETF (INP) was up nearly 49% on the year, when this research report was written. And the India Fund Inc. (IFN) not only has a good performance record [up 46% in the past six months], but has a reputation for handing out fat dividends. 

Vietnam and the Philippines are also excellent emerging markets. Money Morning has extensively covered each country’s growth record and identified profitable entry points for investors.

But if you are looking for something that hasn’t really got going yet, what about Thailand?

Thailand’s been showing signs of a looming spike in growth. It’s the cheapest market in Asia, with a forward P/E of about 11, according to Merrill Lynch.

But without a Thai-targeting ETF or Thailand companies that are SEC-registered, American investors are limited to companies heavily invested in Thailand, or broader indices. One such is the FTSE/ASEAN Index Series, which covers Thailand, Indonesia, Malaysia, Singapore and the Philippines.

Just remember: Thailand is cheap for a reason – meaning we’ll be speculating, rather than investing, at this point in that market.

It is also worth remembering that while all bubbles eventually end in tears, there isn’t much point in fighting them while they’re building. As Buckland and Sharp-Pierson discovered, "investors who try to fight the re-rating of these markets could suffer the same fate as those who tried to fight Japan in the 1980s, and TMT in the 1990s."

In short: Right call, wrong time.

Bubble or Not, Resources and Commodities Will Growth

There’s another aspect to the emerging-market bubble story: The worldwide resources boom.

Even if the U.S. economy comes unstuck, and China no longer finds it as straightforward to export its goods, the country will still need raw materials to continue its infrastructure investment. China can’t just grind to a halt, partly for fear of the resulting social unrest. That means the good times for commodity-related firms should continue for a long time to come. Now, of course, we don’t want to get carried away by a good story, even when it comes to our favorite sector. So let’s look at the valuations.

Until very recently, most of the big miners were trading at P/E ratios of 10 or less. That’s starting to change, and in a big way. BHP Billiton Ltd. (BHP), a longtime MoneyWeek favorite, was recently up more than 70% from a year ago. Rio Tinto PLC (RTP) was up 43%.

The Financial Times reckoned the sector "has the look of a bubble," but we can’t quite see where that look is. Sure, stock prices have gone up, but even now the forward P/E for the global metals-and-mining sector was recently still only 13, still below the 10-year average of 15 times, and well below this decade’s highs of 20 times leading earnings. And wariness among mining firms has been partly responsible for holding back production growth – even though most metal prices "are far above the levels require to justify investment."

There’s no bubble in the oil sector, either. BP PLC (BP) and Royal Dutch Shell PLC (RDS.A) are trading at P/E multiples of around 11, and are still being largely ignored by investors, despite the sharp rise in oil prices.

Given that oil prices look like they’ll remain strong – and far above the levels analysts used to forecast earnings for the oil majors – we believe that blue-chip oil firms like these will soon start to benefit from the rush into the resources sector that miners have started to see.

Money Morning staff writers contributed to this report.

News and Related Story Links:

• Money Morning:
  Vietnam Growing at Exceptional Rate… American Investors Looking for Good Entry Point .

• Money Morning:
  The Philippines’ 7.5% GNP Growth is No Fluke.

• Money Morning:
  Global Investing: Has Wall Street Rigged the Game?

I’ve been telling you for months, now, that the subprime mess isn’t over.

But contrary to what you might be hearing in the mainstream news, the Four Horsemen of the Financial Apocalypse aren’t thundering their way to our homes right now, either.

In fact, savvy investors will have the chance to make a mint with some financial sector bets in the months to come, just by being in the right place at the right time.

I’ll explain just how you can do that in a minute. But first, let’s see why this subprime mess still isn’t over.

Merrill and Citi and Bear, Oh My

There’s no doubt that Merrill Lynch & Co. Inc. (MER) and Citigroup Inc. (C) are each shaking things up internally. As well they should be.

Those two behemoths [with a couple additional votes for The Bear Stearns Cos. Inc. (BSC)] are the poster children for greed, avarice and the"we-know-better-than-the-little-people" attitude that’s been so prevalent among the big financial players in this trillion-dollar subprime saga.

Unfortunately, they’re not alone.

I’ve long believed that there’s at least an additional $1 trillion of subprime slime out there – just waiting to rain havoc on investor portfolios. And just this week, in an interview on CNBC-TV, PIMCO bond guru Bill Gross made the same prediction.

The subprime mortgage market remains a "$1 trillion problem," Gross, the chief investment officer of Pacific Investment Management Co., or PIMCO, said during the interview."There are $1 trillion worth of subprimes … basically garbage loans."

Merrill stunned investors last week when it announced a third-quarter write-down of $8.4 billion, and booked a $2.3 billion loss that was several times what the company had forecast only weeks before. And Citi has projected write-downs of as much as $11 billion.

But those are just the tip of the iceberg.

And investors are the RMS Titanic.

The Creeping Terror

The somewhat sobering truth of the matter is that nearly everybody in the financial sector – from American Express Co. (AXP) to Wells Fargo & Co. (WFC) – has subprime-related debt in their portfolios. Some, like investment giant Goldman Sachs Group Inc. (GS), have elected to make up valuations – and have produced seemingly huge gains in the process – while others are conceding they haven’t a clue as to how they should value this stuff.

Nomura Securities Inc. (NMR) exited the U.S. mortgage business altogether, slashing its exposure and posting a third-quarter loss, opting to focus on its core investment-banking business in Japan. Still other companies have declared billions in write-downs and are hoping like hell this is where it ends.

I’m not so sure it will – stop, that is. That old saying about "bad pennies" seems especially apropos right now.

Two reports released yesterday (Wednesday) back this up. Citigroup’s banking-industry analysts predicted that banks may be looking at $64 billion in write-downs on subprime-backed debt, while the Royal Bank of Scotland Group PLC (RBS) projected bank write-downs may reach $250 billion to $500 billion because of the worldwide credit mess.

“Of the many skeletons hiding in the subprime closet, write-downs on banks’ positions on [collateralized debt obligations] of [asset-backed securities] are probably the scariest," London-based banking analyst Matt King wrote in a debt-market report released yesterday.

Profit Plays to Consider Now

Let me now tell you how to profit from what’s going to happen next.

• First, if you believe there’s another big financial-shares sell-off in the offing, buy a small, speculative position in the Pro-Shares Ultrashort Financials (SKF) exchange-traded fund. The more financial stocks get walloped, the higher this leveraged ETF increases in value.

• Second, once banks and other finance-sector players get left for dead, pick up a few shares of the ProShares Ultra Financials (UYG) ETF, because these companies will end up being terrific long-term investments at depths we’ll not likely see again – at least not in this generation. Plus, by essentially purchasing a"basket" of these stocks, you’ll diversify away the risk of the one or two companies that are certain to fail. You’ll know when the timing is right for you to make your move when you see a story on the cover of Newsweek or Time portraying the end of the banking industry, or some other such gloom-and-doom scenario.

• Third, if dividends are more your speed [and they should be], you could at the same time also pick up the KBW Bank Index (KBE) ETF, which offers less diversification, but features a nice 5% yield – which never hurts.

It’s important to understand that the financial-services sector will rebound – and probably a lot faster than most investors expect. And because the sector leaders are the"global titans" – the best in class companies that are crucial to global finance – you don’t want to be without them.

News and Related Story Links:

• Money Morning Investment Research Report:
  Could Goldman Sachs Explode? How to Dodge the Ongoing Mortgage Mess.

• Money Morning News:
  Citigroup’s Troubles Continue to Grow.

• Money Morning News:
  O’Neal Finally Out at Merrill Lynch.

• Reuters:
  Gross: Subprime Mortgage Market a "$1 Trillion Problem."

• Bloomberg News:
  Subprime CDO Write-downs May Reach $64 Billion, Citigroup Says.

• RMS Titanic:
  
  Official Web Site.

• Titanic.com:
  Community Web Site.

• Bartleby.com:
  The New Dictionary of Cultural Literacy [“A Bad Penny Always Turns Up."]

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:

• Money Morning News Analysis:
  The Merrill Lynch "Surprise" Fuels More Subprime Uncertainty.

• The Wall Street Journal:
  Great Moments in Accounting.

• Reuters:
  FASB to Discuss Delay of Valuation Accounting Rule.

• Money Morning News:
  Acer Leapfrogs Lenovo for the No. 3 Spot in the World PC Market.

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

• Yahoo Finance:
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• CNNMoney.com:
  Citigroup Posts 57 Percent Drop in 3Q.

• Money Morning Investment Research Report:
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• Money Morning News Analysis Story:
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• Google Finance Profile:
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• FREE Money Morning Investment Research Report:
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With U.S. Federal Reserve policymakers slated to review the nation’s interest-rate situation this week, investors spent last week scrutinizing corporate earnings reports in search of signs that the “mortgage challenges” facing the U.S. economy might be limited to financials and housing. With about 150 Standard & Poor’s 500 Index companies having reported last week, the most optimistic predictions are so far for a break-even quarter – at best.

But for the week, at least, the overall news wasn’t half bad.  While Countrywide Financial Corp. (CFC) surprised no one by reporting a loss of $1.2 billion, management expects the company to return to profitability next quarter (wishful thinking?).  Merrill Lynch & Co. Inc. (MER) was forced to write-down more than $8 billion in mortgage-related loans and other debt, a sign that the company perhaps should have been a bit less “bullish on America” [Now the question of the day may be this: Is Wachovia Corp. (WB) bullish on Merrill?]

On the positive side of the ledger, drugmakers Merck & Co. Inc. (MRK) and Bristol Myers Squibb Co. (BMY) reported strong quarterly profits and such diverse companies as E.I. du Pont de Nemours & Co. (DD (chemicals), American Express Co. (AXP)  (financial services), Royal Dutch Shell PLC (RDS.A, RDS.B) (energy) and AT&T Inc. (T) (telecommunications) each had favorable showings, as well.  Techs continued to surpass expectations as Apple Inc. (AAPL) rode the wave of i-Phone (and i-Pod and Mac) popularity, while Microsoft Corp. (MSFT) also reported strong sales of its popular video game, Halo 3 (though the company also gave up its losing battle against European regulators over anti-trust issues).

Likewise Nintendo Ltd. (NTDOY) and Sony Corp. (SNE) reported brisk sales for the last quarter (and offered further proof that video games may be recession-proof).

Housing Woes to Continue

Even so, no week would be complete without a mortgage debacle update. And last week, a few troubling reports and comments made headlines again, making it clear that this problem isn’t going away anytime soon (as if that wasn’t already obvious to most all of us).  The Congressional Joint Economic Committee projected that foreclosure rates would continue to rise over the next year-and-a-half as an estimated 2 million subprime mortgages move closer to their reset date.

The “man, the myth, the legend” known as Buffett [not Jimmy, but Warren of Berkshire Hathaway fame (BRK.A, BRK.B)] thinks that consumers will be dealing with this fiasco for another two years, although the economy will prove resilient and will somehow survive without permanent damage.  And, finally, the “man, the myth, the legend” (though from a negative perspective), Angelo Mozilo, of Countrywide infamy, informed investors that delinquencies are “bleeding into prime mortgages.”  Another type of loan – known as an “option arm” – is starting to show up more and more on bad debt reports.

While the underlying borrowers may have (slightly) better credit than subprime, these mortgages offer such features as “negative amortization” (increasing loan balances) and often required very little (if any) documentation to confirm income and assets, two recipes for disaster.  Countrywide reported that 5.7% of such mortgages are at least 30 days past due (a far cry from the 29.08% of subprime borrowers who are now behind).  Nice going, Angelo, for your role in the story that simply won’t go away (but thanks for that “cockeyed” optimism for the quarters to come). 

Equities reacted well to the decent earnings as investors turned a blind eye to record-setting oil prices that traded above $90/barrel (inflation anyone?).  The Nasdaq Composite Index, in particular, benefited from the positive tech news, though uncertainty remains as earnings season continues and investors again focus on another “man, myth, legend.” Next week, Fed Chairman Ben S. Bernanke and his policymaking FOMC posse may even have a thing or two to say about Mozilo and Buffett (Warren, that is).
   

Economically Speaking…     

*  Reflects changes in interest rates over various time frames. 

Fed in the Spotlight Again

Has it been six weeks already?  It seems like just yesterday that Gentle Ben surprised the world (maybe that’s a tad strong?) by cutting the Fed Funds Rate by half a percentage point to 4.75%.

Well, what “tricks or treats” does Mr. Popularity (for the time being) have up his sleeve for an encore this week?  On the surface, the decision seems to be an easy one.  The economy has slowed (and not just housing); corporate earnings reflect those current mortgage struggles; and everyone seems to be predicting foreclosures to get worse (except maybe Countrywide).  Then again, inflation is never far off the Fed’s radar screen and $90+/barrel oil will not go unnoticed.  The powers-that-be may be hesitant to take additional action with such threats of price pressures.  The smart money seems to be on another rate cut – this time 25 basis points. But whoever said analysts/economists are smart?

Housing data highlighted last week’s economic reports and again the results were nothing to “write home” about (for those who can still afford their homes).  Existing home sales plunged for the seventh-straight month in September, posting their worst one-month decline since 1999.  Additionally, the mean sales price had dropped by 4.2% over the past 12 months.  Though new home sales actually rose in September (+4.8%), sales activity actually remains more than 20% below last year’s level

Here’s to doing the right thing, Mr. Chairman: Don’t let those naysayers “spook” you on Halloween. 

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:

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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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The U.S. banking trio of Citigroup Inc. (C), J.P. Morgan Chase & Co. (JPM) and Bank of America Corp. (BAC) yesterday (Monday) announced that they were setting up a new fund – perhaps as large as $100 billion – to buy mortgage debt held in "Securitized Investment Vehicles" (SIVs) controlled by Citigroup.

When you have belly-crawled your way through the muddy and crater-strewn minefield of jargon all these deals seem to generate – keeping your head beneath the whizzing bullets of risk – and through the minefield of jargon all these deals seem to generate, this one has a simple message for the retail investor, a of Gypsy’s Warning: Don’t Invest in Anything Related to This Area. [For our news report on the formation of this fund, and the negative effect it had on stock prices yesterday, please click here.]

In short, if you want to avoid stinging losses from the still-dangerous subprime-mortgage crisis – and hope to stroll out of this debt jungle with an actual profit to boast about – there are three investments to avoid, and one stock to buy.

We’ll get to the stock to buy shortly. But, first, here are the three areas to steer clear of if you want to avoid the stinging pain of losses. The three big "subprime don’ts" are:

• Don’t buy securitized mortgage bonds.
• Don’t buy asset-backed commercial paper, which this new investment fund will issue in profusion.
• And don’t buy shares in any of the banks involved in the deal, or that you know is still a player in the mortgage market.

That may seem a little harsh and sweeping, so let me explain.

The Mortgage Market Ain’t No ‘Wonderful Life’ Anymore

As we all now know, the U.S. mortgage market has changed in the last 25 years. In the old days, like back when the late great actor Jimmy Stewart portrayed character George Bailey in the 1946 movie classic, "It’s a Wonderful Life," local institutions like the Bailey Bros. Building & Loan lent money to local borrowers, like Ernie the Cab Driver (played by actor Frank Faylen).

Today, the Building & Loans are gone, and lending is not longer local – its global (just look at how many foreign banks got their tail-feathers singed because of investments in U.S. subprime mortgage debt).

Mortgage brokers arrange the mortgages, which are then packaged by Wall Street and sold to investors all over the world. That appears to have made mortgages rather more expensive than they once were; it has certainly greatly enriched Wall Street and the "mortgage banking" industry (which is really more of a "mortgage brokerage" industry, because few of the firms do any actual lending).

As we’ve all discovered, this new mortgage system also has a fatal flaw: Nobody was responsible for vetting the credit-decision on the actual mortgage, yet everybody made money from packaging it and then selling it to somebody else.

With easy money being pumped out by the Fed, this had the inevitable result of generating a lot of unsound mortgages – subprime mortgages are around 10% of the total currently, compared with a maximum range of 1% to 2% in the early 1990s.

The Downside of Asset-Backed Debt

In another wrinkle, many of these mortgages weren’t even purchased by end investors, at all, but by SIVs similar to the one that Citi and its two compatriot banks unveiled yesterday. The SIVs went on to buy mortgages, and would issue asset-backed commercial paper (ABCP) to pay for them.

Asset-backed commercial paper (ABCP) is a short-term corporate debt – usually due in less than a year – that is backed by such assets as real estate or mortgages. It’s perhaps the  latest example of financial engineering in an area known as "collateralized debt obligations," or CDOs, which are sold on secondary markets. Financial instruments such as these were created to create additional economic liquidity.
When used correctly, they achieve that objective superbly, enabling companies, banks and other financial institutions to ‘monetize,’ or sell off, debt, in turn providing capital that can be used to finance other projects. Unfortunately, as has been demonstrated time and again, when Wall Street uses engineered financial instruments – such as derivatives – either as devices for speculation, or outside appropriately prudent investing parameters, the results are disastrous.

With ABCP, a key problem is that the loan originators won’t also be the loan collectors, since by definition the asset-backed debt will be sold to other investors. Some experts fear these split roles may make lenders much-less disciplined about lending standards, substantially boosting default rates.

When the subprime mortgage mess "jumped the shark," and became an international problem earlier this summer, it became just this kind of problem. Not only did U.S. banks and mortgage-lending firms not use appropriate credit-qualifying standards.

Had the U.S. commercial paper market remained open, liquid and efficient, all would have been well. The SIVs would profit from the difference between the yields on the mortgages and the cost of the commercial paper (if the mortgages were at a fixed rate, while the commercial paper cost went up and down with short term rates, an interest rate swap employed as a ‘hedge’ would solve the problem). But the growing global subprime scandal then generated a crisis of confidence in the worldwide commercial paper market, forcing central banks worldwide to intervene. They injected capital into the marketplace, and U.S. Federal Reserve policymakers on Sept. 18 finally slashed short-term interest rates by a bigger-than-expected half a percentage point.

The result is a $12 trillion mess – a morass of mortgage debt of all types and of varying risk levels.

Possible Loss Rates

The bulk of the debt is relatively safe, and much of it is actually covered by one of the so-called "Government Sponsored Entities" (GSEs) that include Fannie Mae (FNM) and Freddie Mac (FRE) (which almost certainly means ultimately by the taxpayer if they get in trouble). Some of the debt is even guaranteed by Ginnie Mae, which is the government directly. And there is still some fixed-rate mortgage debt issued several years ago, when house prices were much lower than they are today. So even in a 15% to 25% home-price decline – which now seems possible – most of the mortgage debt will be okay.

Even so, market-loss estimates are still way too low, meaning the problem is still getting worse. But you can be reasonably confident that, at most, $3 trillion of the $12 trillion in debt is at risk. Of that total only $1 trillion of the $3 trillion will lose more than a modest portion of its principal. The bottom line: We’re probably looking, realistically, at mortgage-debt losses in the $500 billion to $1 trillion range.

That’s not a big percentage of the total – we’re talking about a range of 4% to 8% of all mortgage debt, here. Still, that’s a lot of money – about a month’s worth of U.S. Gross Domestic Product (GDP).

What’s more, the $1.2 trillion asset backed commercial paper (ABCP) market, mostly invested in some of these mortgages, has recently shrunk to about $900 billion. The reason: Investors have refused to take on the risk they perceive they’re shouldering when they buy ABCP. That’s left the big banks like Citi, who sponsored these things, to find the missing $300 billion somewhere else.

In a free market, this wouldn’t matter too much. The mortgage bond market would be tugged to and fro by the forces of willing buyers and willing sellers, and you could be confident that whatever price emerged for a mortgage bond or ABCP, that was the market’s real estimate of its true value. You might think the market was being too optimistic or too pessimistic, but on average, if you bought a $1000 mortgage bond for $850, you could expect to get $850 of value.

But this isn’t really a free market. Citigroup, J.P. Morgan Chase and Bank of America, with the encouragement of the U.S. Treasury, are going out to borrow $100 billion and invest it in mortgage bonds, mostly those residing in Citibank SIVs. In that way, they can prop up the market and so avoid recognizing the losses that the SIVs and their sponsors should be recognizing from investing in lousy mortgages.

The One Profit Play to Make

If this deal goes forward – and it seems very likely that it will – the market for mortgage bonds will no longer reflect that efficiency-inducing balance between willing buyers and willing sellers. Instead, it will reflect that balance – with a $100 billion thumb on one side of the scale: Anyone buying mortgage bonds will be paying more than their true market value.

It’s a distortion of the market. Mortgage bond prices may rise a bit given this $100 billion bailout fund, so if you’re holding them, sell into the rise. If you’re holding asset backed commercial paper, make the SIV and its sponsoring bank redeem it when it comes due – better for this rubbish to be on Citi’s balance sheet than on yours. And avoid the shares of the big U.S. banks that have been active in the mortgage market – thinking up clever tricks to avoid recognizing reality will do their shareholders no good in the long run. 

Finally, a recommendation as to what you should buy instead, assuming you still want some of your money in the financial-services business, which is a good idea, if you’re to have a truly balanced portfolio.

Our choice: Nomura Holdings Inc. (NMR), the parent company of the largest investment bank in Japan. One big thing that Nomura has going for it is that it has just exited the U.S. mortgage market, taking write-downs totaling $1.4 billion to do so. It also announced it will report a loss for the second quarter ended Sept. 30.

Losses aren’t great, but uncertainty is far worse. And what this means is that Nomura has put this whole saga firmly behind it, removing the veil of uncertainty that still covers other U.S.-based large banks.

While Nomura has, over the last 25 years, had an appalling tendency to waste its shareholders’ money on ill-considered foreign ventures in which it is inevitably a minor player, this write-off will at least for a time lessen the risks of further such forays. Meanwhile, in the Japanese market, which is growing nicely and where real estate prices are far below their 1989 highs and beginning to recover, Nomura remains a truly dominant player. With the stock beaten down, it looks like a good time to buy.

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