We’ve been warning you since the start that the subprime crisis would have some real staying power.

Indeed, every time optimistic prognosticators have predicted an end to this global financial debacle, we’ve had the same response: Don’t you believe it.

Again just recently, after several big banks announced yet another round of major write-offs – all of them related to the subprime crisis, albeit indirectly – analysts, and even some banking-industry executives, said the write-downs were coming to an end.

Once again, we advised readers to avoid losing their heads over such heady optimism. And again, we were right.

The latest victims of the subprime crisis – mortgage giants Fannie Mae (FNM) Freddie Mac (FRE) – will be in the spotlight this week as investors, economists, bankers, mortgage brokers, homeowners, and politicos alike monitor the fate of these institutions. And here are the questions that will be asked – and hopefully answered – in the process:

• Are these government-sponsored enterprises (GSEs) too big to fail?
• Are their capital positions not as dire as some claim?
• Will the government nationalize them (at the taxpayers’ expense)?
• Will residential borrowing costs shoot through the roof?

The answers will go a long way toward determining how much longer we have to tell you "don’t you believe it" each time some analyst says the subprime crisis is over.

And some of those answers could well come today (Monday), especially after reports surfaced yesterday (Sunday) morning, stating that the U.S. Treasury was working on a rescue plan for the two government-sponsored mortgage firms. [For a related story detailing the Fannie and Freddie debacle in today's issue of Money Morning, please click here].

Investors also will have to turn at least some of their attention to earnings season (remember that?) as some key financial companies report: US Bancorp (USB.L) (Tuesday), State Street Corp. (STT) (Tuesday), Wells Fargo & Co. (WFC) (Wednesday), Merrill Lynch & Co. Inc. (MER) (Thursday), JP Morgan Chase & Co. (JPM) (Thursday), and Citigroup Inc. (C) (Friday).

Even earnings season poses some questions related to the subprime crisis:

• Will these results lead to more write-downs and additional capital infusions – further fueling the subprime crisis?
• Are those foreign sovereign wealth funds still looking for more American investments?
• Will the high-tech sector be able to offset some of the financial-sector pain, as it has so many times over the past couple of years?

Technology also takes center stage as Intel Corp. (INTC) (Tuesday) and Microsoft Corp. (MSFT) (Thursday) report quarterly results.

In other tech news, Yahoo! Inc. (YHOO) continues to make for interesting news, and yesterday (Sunday) rejected a new takeover/breakup offer from Microsoft and corporate raider/investor Carl Icahn.

Investors get another look into the inflation picture as both June Producer Price Index (PPI) and Consumer Price Index (CPI) are released.  Have the higher energy costs started to work their ways into other sectors of the economy?  Are companies passing along these costs to the ultimate consumer?  (Remember, the so-called "core" data – which excludes volatile food-and-energy prices – is useful, but check out the full inflation picture for a change).

Finally, June retail sales may look promising as those government checks will be reflected in the data, but don’t be fooled.  This month, consumers are back out on their own.

Market Matters

And then panic set in.  It’s one thing for The Bear Stearns Cos. Inc. (BSC) with all of its interconnected relationships to be close to failing and require a "bailout."  But what about two government sponsored entities (GSE) which own or guarantee $5 trillion in mortgages and serve as the backbone of that entire industry?

Surely, Freddie Mac and Fannie Mae have made news in the past (accounting irregularities, ineffective management) and have long been targets of certain politicos who have warned about a "too big to fail" mentality.  Well, after losing a combined $11 billion (as of March 31) and raising $20 billion to shore up balance sheets, both entities face another major liquidity crunch and are in dire need of new infusions.

Lehman Brothers Holdings Inc. (LEH) analysts (like they have room to talk) and St. Louis Fed President William Poole were among the "experts" who implied both GSEs were on the verge of collapse without an immediate capital investment.  Fannie and Freddie shares plunged to their lowest levels in more than 16 years and firms with significant mortgage holdings (investment-related and REITs) fell in lockstep. Though the Office of Federal Housing Enterprise Oversight (OFHEO) and Treasury Secretary Henry Paulson offered their best political spin by claiming the GSEs are "adequately capitalized," investors were not buying (literally) as some awaited news of a government "bailout."  A lonely, optimistic voice in the crowd emerged Friday as Citigroup (as if it doesn’t have its own problems) stepped forward and made the statement that "we expect cooler heads to prevail…we believe the recent sell-off in the shares of Freddie and Fannie is overdone." 

The Freddie-Fannie news overshadowed virtually every other business story of the week.  Staying within financials, Merrill Lynch is close to raising more capital of its own (possibly new write-downs on the horizon?) as it looks to reduce its investments in BlackRock Inc. (BLK) and Bloomberg LP.  Likewise, Citi is selling its German banking unit to France’s Compagnie Financiere du Credit Mutuel SA for more than $7.5 billion.

Outside of financials, Dow Chemical Co. (DOW) is acquiring Rohm and Haas Co. (ROH) for $15 billion in a cash deal, and General Motors Corp. (GM) will be handing out more pink slips (so what else is new?) as it reevaluates most of its brands.  Oh yeah, earnings season kicked off last week with Alcoa Inc. (AA) beating estimates and General Electric Co. (GE) affirming its profit forecast for the year.  Thomson Reuters predicts that Standard & Poor’s 500 companies lost 13% in the 2nd quarter, with financials leading the slide with related earnings falling by more than 65%. 

Oil prices ended a highly volatile week on a very negative note.  After tumbling more than $9 a barrel in two days, crude once again soared to record levels as Iran threatened the world (or, at least, Israel) by test-launching a few missiles.  After starting the week around $145, prices plunged to $136 on Tuesday before rallying again (to $147 at one point Friday).

The Dow Jones Industrial Average and the S&P 500 struggled as negative news from financials and the late week oil-price spike brought out the bears (again).  The Dow even fell below 11,000 for the first time in two years before closing slightly above that level.  Meanwhile, the S&P 500 hobbled into "bear" territory, as the index has reached a point that was down 20% from its October 2007 highs.  As the weekend began, some investors speculated that U.S. Federal Reserve Chairman Ben S. Bernanke, Treasury Secretary Paulson and others might participate in more "round the clock" meetings over this Freddie-Fannie fiasco.

Is it time to panic yet?                        

Economically Speaking

No rest for the weary. Just because the economic calendar was light last week doesn’t mean the Fed officials were taking any time off.  Instead, a "power-hungry" Bernanke was pushing for the central bank to get more regulatory authority over the financial markets.  He believes that such a move would help ensure damage control in case of future potential failures (as we saw with Bear Stearns, and may soon see with the dynamic duo of Freddie and Fannie).

In congressional testimony, Bernanke spoke of the Fed’s continued creative moves to assist in the current financial crisis (this entire mess stems from the subprime crisis); he suggested that investment firms should be able to borrow from the discount window beyond the mid-September deadline (and into 2009).  Late into the week last week, the week, reports claimed that Freddie and Fannie likewise would have access to the Fed’s discount window. Whether that will be part of the rumored Treasury Department bailout we mentioned remains to be seen.

Across the pond, European Central Bank President Jean-Claude Trichet implied that his policymakers stand prepared to raise rates further should threats of inflation continue to rise across Europe. 

Last week, retailers reported "same-store" sales data (stores open at least a year) for June and the results were not half bad (at least, not for discounters).  Wal-Mart Stores Inc. (WMT), Costco Wholesale Corp. (COST), and BJ’s Wholesale Club Inc. (BJ) each reported better-than-expected sales as consumers went "crazy" with those government rebate checks (or as crazy as a $300 to $600 refund will allow).

Children’s Place Retail Stores Inc. (PLCE) also reaped the benefits of the government’s generosity, though traditional mall-based stores like Limited Brands Inc. (LTD) and The Gap Inc. (GPS) failed to capitalize.

After struggling through a poor June, Nordstrom Inc. (JWN) warned that its 2nd quarter results might not meet prior forecasts.  Analysts have grown concerned that the rebate checks were like a tailwind that temporarily filled the sails of some of the big store chains, enabling them to navigate some of this slowdown – but that these checks will ultimately leave the store chains becalmed going forward.

On that note, Morgan Stanley (MS) reduced its earnings forecast for the entire retail sector for 2009. 

Weekly Economic Calendar

News and Related Story Links:

• Money Morning Financial Analysis:
  Avoid the ‘Resurgent’ Homebuilding Sector and Go Global for Profits.
  |
• Wikipedia:
  Government Sponsored Enterprises (GSE).

• Money Morning News Analysis:
  Freddie Mac and Fannie Mae Rocked by Liquidity Concerns.

• The BBC:
  Yahoo rejects new break-up offer.

• Money Morning News:
  Dow Makes $18.8 Billion Offer for Rohm and Haas.

• Forbes/Thomson Financial News:
  U.S. Treasury Working on a Rescue Plan For Fannie Mae and Freddie Mac – Report.

Wachovia Corp. (WB), the fourth-largest U.S. bank, stunned investors yesterday (Monday) by posting a surprise first-quarter loss, announcing a dividend cut and revealing plans to raise $7 billion in capital.

Chief Executive G. Kennedy "Ken" Thompson said the "precipitous decline in housing market conditions and unprecedented changes in consumer behavior" damaged the bank’s results. Also inflicting damage was Wachovia’s $24.2 billion acquisition of adjustable-rate mortgage lender Golden West Financial Corp. in 2006, a move that was made at the pinnacle of the U.S. housing boom.

The Charlotte, N.C.-based bank reported a net loss available to common shareholders of $393 million, or 20 cents per share, compared with a year-earlier profit of $2.3 billion, or $1.20 per share. Excluding "one-timers," the loss was $270 million, or 14 cents per share. Revenue on a taxable equivalent basis fell 5% to $7.9 billion.

The consensus estimate from analysts was for Wachovia to post a profit of 48 cents a share on revenue of $8.37 billion, according to Reuters Estimates.

Wachovia’s shares plunged $2.26 each, or 8.13%, to close at $25.55. They traded as low as $24.65.

Because yesterday was the first day in what’s expected to be a big week for corporate earnings reports, the markets punished financial shares, sending the Standard & Poor’s Financial Sector down 2.4%. In fact, financial shares in the Standard & Poor’s 500 Index skidded for the fifth-straight day, reaching their lowest point since March 17, when the group of banks, brokers, insurers and real-estate investment trusts dropped to an almost five-year low, Bloomberg News reported.

All 23 banks and 28 of 30 diversified financial companies fell, Bloomberg said.

"Today all the troubles were in financial services," Linda Duessel, a market strategist at Federated Investors in Pittsburgh, told Reuters. "This is expected to be a big week in earnings and it feels like the calm before a potential storm when we get more earnings information."

Wachovia said it set aside $2.83 billion for credit losses – that’s up from $177 million a year earlier and nearly twice the $1.5 billion the banking firm set aside in the fourth quarter. Net charge-offs (loans it doesn’t expect to be repaid) quintupled from a year earlier, reaching $765 million.

Story continues below…

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To conserve $2 billion a year in capital, Wachovia is slashing its quarterly dividend 41%, from the current 64 cents all the way down to 37.5 cents per share. To raise capital, Wachovia will include public offerings of common and convertible preferred stocks.

The company ended the quarter with a Tier-1 capital ratio of 7.5%, up from 7.4% at year-end, and well above the 6% level that regulators say indicates a bank that is considered to be "well-capitalized."

The ratio measures a bank’s ability to cover losses.

"The news out of Wachovia would suggest the environment has probably deteriorated faster in recent weeks, to a greater extent than people may have anticipated,” Jonathan Armitage, the New York-based head of U.S. large-cap equities at London-based Schroders PLC, told Bloomberg. Banks now face "a tougher environment for the consumer, whether it’s housing- or mortgage-related, or direct-to-consumer lending.”

News and Related Story Links:

• Reuters:
  Wachovia posts surprise loss, eyes $7 billion capital

• Bloomberg:
  U.S. Stocks Retreat After Wachovia Reports Unexpected Loss

• Reuters:
  Wachovia hits banks, cancels oil gains; stocks slip

Soaring demand in emerging markets helped HSBC Holdings PLC (HBC) overcome a $17 billion hit on its exposure to subprime mortgage defaults and log record net profits in 2007.

HSBC reported a jump of more than 20% in net profit, which climbed to a record $19.13 billion last year as total income increased 25% to $87.60 billion. The company also raised its 2007 dividend by 11% to 90 cents.

The company said profits from its U.S. operations slumped more than 98% to $91 million as a result of surging bad-debt charges, which soared 63% to $17.24 billion. In addition to those charges, HSBC said it took a $2.1 billion write-down in its global portfolio on its exposure to asset-backed securities, leveraged loans and holdings guaranteed by bond insurers.

However, a number of strong performances in emerging markets such as Hong Kong, China, India and Latin America buoyed the company in the face of the U.S. downturn.

Annual profit rose 42% in Hong Kong, and leapt 70% in the rest of the Asia-Pacific region. The bank also reported pre-tax profit of $2.18 billion from its Latin American operations, up 26% from 2006.

"If ever proof were needed about the benefits of diversification, these numbers from HSBC fall squarely into that category," Richard Hunter, head of U.K. Equities at stockbroker Hargreaves Lansdown PLC, told Reuters.

The bank got 78% of earnings from emerging markets, up from about 50% in the first half.

"The economic slowdown and the credit outlook in the U.S. may well get worse before they get better," Stephen Green, company chairman, said in a statement. "With significant parts of the international financial system in developed markets still in difficulties, HSBC’s emphasis on faster-growing emerging markets means that we are better positioned than many of our competitors."

Moving Out of the U.S. Market

While successful operations in emerging markets bolstered the HBSC’s bottom line, the company is still far from clearing the prickly subprime thicket. 

Activist investor Knight Vinke is pushing HSBC to dispose of HSBC Housing Corporation (HFC), the company’s U.S. lending arm, MarketWatch recently reported.

"This is clearly not a business which HSBC should own in the future, regardless of what management says, and the financial costs of downsizing it appear not yet to have been properly taken into account by the market," Knight Vinke said.

HSBC bought HFC in 2003 when the company was known as Household International, for $15.5 billion. The company lent directly to customers with subprime credit, the contingent of borrowers at the very center of the U.S. housing disaster and resulting credit crisis.

Knight successfully lobbied HSBC to jettison its French regional banking subsidiaries, which included 400 branches, for $3.2 billion last week.

HSBC has already cut 6,000 jobs in the United States, and reduced the number of active branches to 400 from 1,000.

Knight and others would like the bank to invest more in emerging markets where HSBC has had so much success. But such a move could easily backfire, as many analysts expect that U.S. turmoil will eventually catch up with emerging markets.

HSBC runs the risk of upping its exposure to those markets just before their economies lose traction. Such a mistake would be eerily similar to the HFC miscalculation made five years ago.

News and Related Story Notes:

• Bloomberg:
  HSBC Second-Half Net Rises 17% as Asia Offsets U.S.

• Reuters:
  HSBC Profits Up 10 Pct, Bad Debts Hit $17 Bln

• MarketWatch:
  HSBC holder Knight Vinke calls for break with U.S. lending arm

• Money Morning:
  Dresdner Bails Out Struggling SIV

I don’t know whether to be furious or relieved.

While at our Oxford Club Chapter Meeting in Colorado Springs last week, I happened to learn that Countrywide Financial Corp. (CFC) was planning to host several dozen mortgage company reps at the nearby Ritz-Carlton Bachelor Gulch ski area in Avon.

Unfortunately, public disclosure by The Wall Street Journal and other papers ruined their plans and the Calabasas, Calif.-based Countrywide cancelled at the last minute.

Countrywide claims to have cancelled all similar events, too, for the rest of the year "in light of recent events."

It’s for the best – believe me – for "swank" doesn’t begin to describe just how nice the Avon Ritz really is. For starters, weekday rooms there start at $750 a night.

As reported in the Rocky Mountain News, the multi-day soiree was set to start with cocktails and ski-fittings. Attendees were then to be feted at Spago on such delicacies as $105 a plate Kobe beef and $140 caviar, before enjoying a multi-day fiesta including hotel rooms, meals, skiing and gratuities – all of which was to be paid for by Countrywide and all of which is in line with annual industry "meetings" they’ve held since the 1990s.

Silly me … I thought the industry was in the dumper and that the company was struggling after taking $1.6 billon in losses during the second half of 2007.

Evidently things at Countrywide are a lot "richer" than most people think – and why shouldn’t they be?

If you recall, we suggested months ago that the real reason Bank of America Corp. (BAC) is buying Countrywide has nothing to do with the hundreds of millions of dollars worth of yearly loan-servicing revenue. Nor does it have anything to do with Countrywide’s dominant market share.

Instead, we posited that BofA was going to use Countrywide’s losses to offset its own taxable income.

Turns out we may have been "righter" than we care to admit.

Under the terms of the deal announced in January, Bank of America agreed to pay $4 billion in its own stock for Countrywide – slightly less than $8 a share. Proponents viewed the takeover bid as a much-needed rescue mission for Countrywide, which many believed to be out of cash at the time.

Just before the offer, Countrywide had seen its stock price plunge about 85% – a decline that steepened in the days immediately before Bank of America launched its bid.
Critics say the buyout offer was a bit on the rich side – especially after BofA Chief Executive Officer Kenneth D. Lewis had already injected about $2 billion into Countrywide to help prop it up last summer as the subprime mortgage crisis started to spiral out of control.

With mortgage defaults escalating, Countrywide was forced to boost its loan-loss provisions, leading to a loss of $1.2 billion in the 2007 third quarter and $422 million in the fourth quarter.
According to tax experts like Robert Willens, who was quoted in Fortune magazine at the time, the deal could be worth billions to BofA by the time all is said and done. In fact, in the first five years it owns Countrywide, BofA will be able to use a total of $1.35 billion of Countrywide’s losses to shelter its income. That works out, incidentally, to $270 million a year.
But here’s the kicker.

If Countrywide’s losses exceed $1.35 billion when the transaction ultimately closes [it's supposed to be finalized in the third quarter, as the two companies continue to work out the details], Bank of America could deduct the rest of the losses without limits beginning in year six.

What a country …run up billions of dollars in losses, hand your executives hundreds of millions in compensation, nearly wreck an entire industry single-handedly, spend millions on boondoggles…and qualify for an IRS sanctioned tax break at the same time!

Where do I sign up?

Wait…I already did. My wife and I got our mortgage through Countrywide. At least we haven’t been "countryfried" – yet.

Maybe that’s why shares of Countrywide rose a penny each after the ski trip was cancelled…to $6.96.

News and Related Story Links:

• CNNMoney.com:
  Countrywide Cancels Ski Trip Meeting.

• Money Morning News:
  Bank of America Will Buy Countrywide for $4 Billion in Stock.

• Money Morning News:
  Countrywide CEO Still Gloomy After $2 Billion Capital Infusion.

With default rates rapidly increasing, credit standards for home equity loans and revolving home equity lines of credits (HELOCs) have tightened, cutting off what was once a reliable source of capital for homeowners.

Following the lead for first mortgage guidelines, lenders are tightening credit standards for home equity loans and lines of credit in the past few months. In the past, the biggest consideration for lenders was the amount of equity in the home, but with mortgage default rates soaring, lenders are requiring higher credits scores and lowering the amount of equity available to borrow against.

A traditional home equity loan, or second mortgage as they are often called, has a set time period and repayment schedule, often at a fixed rate. But HELOCs can be open-ended, allowing homeowners to only take out what they need and then borrow again after repayment.

"You have basically a looming threat of a recession and the probability that unemployment rates are going to rise. That’s going to cause banks to be more cautious," Keith Leggett, senior economist with the American Bankers Association, told MarketWatch.

The weakening U.S. economy has had both positive and negative effects on home equity products. Adjustable rate loans have lowered as the prime rate [tied to the Federal Reserves benchmark rate] has been slashed. But the decrease in housing prices has meant a subsequent decrease in the amount of equity available to homeowners. [For another story in this issue that addresses how the decrease in housing prices is affecting municipal bonds, please click here.]

Countrywide Financial Corp. (CFC) is the nation’s largest home equity product lender with a 9% market share. The California-based lender was forced to take a $704 million charge against its $32.4 billion prime HELOC portfolio in the recent quarter due to defaults, Fortune reported.

The trend is particularly troubling as home equity products have always been riskier than first mortgages. 

"That’s because the first lien takes priority, so if a borrower defaults, the second mortgage gets paid off after the first mortgage does," Pam Hamrick, vice president of LendingTree Loans told MarketWatch. "And with foreclosure volumes breaking records lately, lenders are concerned that first-lien loans will be paid back let alone home-equity lines."

Equally troubling for investors, it is often difficult to gauge the size of a lender’s home equity portfolio. The assets are often carried off balance sheet until there’s a problem as shown by Countrywide. If the home equity defaults persist, the banking industry could be in for yet another round of write-downs. 

Related News and Story Links:

• Fortune:
  Home equity loan defaults soar

• MarketWatch:
  Lower confidence greets lower rates

After an unyielding series of write-downs, losses, and layoffs, financial firms are still struggling to cope with the widespread fallout from the subprime mortgage meltdown. Now, with Goldman Sachs Group Inc. (GS) forecasting another heavy hit to Citigroup Inc. (C) and others in the fourth quarter, it appears the sector’s turnabout remains in the future.

Citigroup may be forced to write off $18.7 billion in the fourth quarter, according to recent Goldman Sachs forecasts. Additionally, Citigroup might be forced slash its dividend by as much as 40% to preserve liquidity. The company announced on Nov. 4 that it was likely to write down its portfolio by another $8 billion to $11 billion.

"It will be a couple of quarters before the current credit crisis is fully digested by the markets," Goldman Sachs analyst William Tanona wrote in a report released last Thursday. "Fourth-quarter trading results are likely to be among the weakest we have seen in some time."

Tanona expects Merrill Lynch & Co. (MER) and JPMorgan Chase & Co. (JPM) to write down $11.5 billion, and $3.4 billion, respectively.

The Goldman Sachs analyst also said there was a possibility Citigroup would cut its quarterly dividend of 54 cents per share to help preserve $5 billion to $10 billion in capital. He rates Citigroup as a "Sell" and both JPMorgan and Merrill Lynch as "Neutral."

Tanona is not the only one predicting more trouble ahead for the battered firms.  Brad Hintz, an analyst at Sanford C. Bernstein & Co. LLC., predicted a $10 billion fourth quarter write-down at Merrill Lynch, resulting in a quarterly loss of $5.10 per share, according to Reuters. Tanona thinks Merrill will suffer a loss that’s closer to $7 a share.

LBOs Another Obstacle For Leading Lenders

And the troubles for the world’s leading lenders don’t end with the subprime-mortgage crisis. Citigroup, Goldman Sachs, Morgan Stanley (MS), JPMorgan, and others, all still are struggling to unload a massive amount of debt accrued from the record number of leveraged buyouts (LBOs) in 2007. 

Some of the companies are offering discounts on the debt of as much as 10% in an effort to clear a $231 billion backlog of high-yield bonds and loans, according to a recent report from Bloomberg News. The news agency reported a record $438 billion in leveraged buyouts for 2007.

Buyout groups use their own funds and debt to pay for takeovers and then expand profit margins by boosting sales and selling off assets. Once profits climb, the new owners recoup their investment – and a hefty profit, besides – by putting the company up for sale, either via an initial public stock offering (IPO), or by selling it outright to a larger corporation.

But that entire transformation process takes time and in the interim the lenders who financed the acquisitions now find themselves in a compromising position. The reason: The collapse of the mortgage-backed securities sector has left investors without a taste for the higher-yielding – and therefore riskier – types of assets. Unable to sell the bonds and loans at face value, and desperate to unload the debt, banks are now selling off the assets at deep discounts.

Lenders first started lightening their debt loads in September when Kohlberg Kravis Roberts & Co.’s lenders sold $9.4 billion of the loans that had been used to finance the LBO of First Data Corp in April. The loans were offered at a 4% discount, which cost Deutsche Bank AG (DB) and four others approximately $360 million.  The banks also issued $2.2 billion of bonds at a loss of $114 million, leaving them with another $10.4 billion in debt that still needs to be sold.

According to JPMorgan, banks still have $161.9 billion of loans – and $69.6 billion of bonds – left to distribute, all of it related to LBOs. Bankers led by Goldman and Citigroup hold $17 billion of unsold debt left over from the acquisition of Alltel Corp.

Bank of America Corp. (BAC), Deutsche Bank, JPMorgan, and others, still are on the hook for $22.3 billion promised for next year’s scheduled buyout of Harrah’s Entertainment Inc. (HET), according to filings with the Securities and Exchange Commission.

"A python that swallowed an elephant is being absorbed through the system," Mario Gabelli chief executive officer of the Rye, New York-based Gamco Investors Inc. (GBL), told Bloomberg. 

And it’s a record-sized elephant at that: The just-concluded 2007 established an all-time record for LBO activity.  As the subprime crisis began to unfold, the total value of LBO deals dropped to $101.9 billion in the back half of 2007, a significant decline from the $336.4 billion in the first six months.

But for the lenders, the damage had already been done. There was just too much deal-related debt washing through the financial markets.

"The market can absorb all of these deals,” John Eydenberg, head of leveraged finance for the Americas at Deutsche Bank in New York, told Bloomberg News. "It is [just] a question of time and price."

Cashing In On Potential Turnaround Profit

Despite the financial sector’s obviously severe problems, many of the large banking institutions still represent potential turnaround plays for aggressive investors. Take Citigroup: Its share price was down nearly 50% in 2007, but some bold Contrarians see that as an opportunity. Citigroup remains globally diversified and many portions of its business still reflect double-digit growth rates.

It’s also trading at a mere seven times earnings. Large globally diversified companies with a P/E of 12 or less are often considered a bargain. And while its stock price is currently hovering around $30, Citigroup’s shares could easily climb back above $60, several contrarians have said.

Outside investors are already scrambling to move back into to Citigroup to fully exploit its profit potential. Most recently, Abu Dhabi Investment Authority sovereign-wealth fund got its foot in the door, investing $7.5 billion for a 4.9% stake in Citi. That’s not to say that the worst is already over for Citigroup. And its shares are certain to remain volatile. But those who are willing to weather the storm now may be very glad they did so in as little as a year or two from now. [For a Money Morning investment research report detailing the investment opportunities in Citigroup, please click here. The report is free of charge].

News and Related Story Links:

• Bloomberg:
  Citigroup, Goldman Cut LBO Backlog With 10% Discounts

• Reuters:
  Citi, Merrill, JPMorgan face larger writeoffs: Goldman

• Money Morning:
  Citigroup: Why This Turnaround Play Has Legs – Big Ones

• Money Morning:
  Why Some of the World’s Savviest Investors Are Buying – Gasp! – Citigroup.

• Investopedia:
  Leveraged Buyouts.

• Investopedia:
  Initial Public Offering (IPO).

• Bloomberg:
  Lehman Raises $3 Billion Fund to Purchase Buyout Debt. 

William Wesney, an upset UBS AG (UBS) shareholder, is suing the Swiss banking giant and its officers, arguing that investors were misled about write-downs related to the faltering U.S. subprime mortgage market.

And he may not be alone. Reuters reported that Wesney is seeking class-action status on the suit, which was filed on behalf of shareholders whom bought stock from Mar. 13 to Dec. 11.

Wesney filed the suit Thursday, just two days after the bank announced a $10 billion write-down.  The same day, UBS also announced a combined $11.5 billion investment from Singapore’s state-run Government of Singapore Investment Corp. Pte. Ltd. (GIC) and an undisclosed investor in the Middle East.

The shareholder suit claims that UBS and certain officers issued statements that "were materially false and misleading because they failed to disclose the company’s failure to [take a] timely write-down [of] impaired securities containing subprime debt," a statement from Wesney’s attorney, Coughlin Stoia Geller Rudman & Robbins LLP said.

Europe-based UBS has now become the continent’s single-biggest victim of the U.S.-led subprime mortgage crisis: The $10 billion write-down announced Thursday follows a previous $3.8 billion write-down announced in October. The bank said that further write-downs were unlikely, but also didn’t rule out the possibility.

News and Related Story Links:

• Reuters:
  UBS hit with shareholder lawsuit over subprime

• Coughlin Stoia Geller Rudman & Robbins LLP:
  News Release

• Money Morning:
  Bad Day in Banking: UBS Offsets $10 Billion in Write-Downs With Sale of $11.5 Billion in Shares to Singapore

President Bush announced yesterday [Thursday] afternoon that an agreement made between the U.S. Treasury Department and lenders will secure interest rates for many subprime borrowers.

The deal hones in on borrowers who will fall behind after their introductory "teaser" interest rates reset to higher levels – sometimes adding hundreds of dollars to a monthly payment – between January 2008 and July 2010. In that span, rates will reset for an estimated 2 million subprime mortgages.

The rate freeze applies to mortgages taken between January 2005 and July 2007. 

The condition: borrowers must not have missed any payments at the lower rate.

The agreement follows weeklong negotiations between big-name lenders such as Wells Fargo & Co. (WFC), Washington Mutual Inc. (WM) and Citigroup Inc. (C) – the latter whose troubles were well documented by Money Morning. Negotiations were primarily about the length of starter rates in subprime mortgages (loans given to people with lower credit scores) and the first wave of defaults in August, Bloomberg reported.

The timing couldn’t be better, as fresh data from Mortgage Bankers Association (MBA) said that the number of Americans behind on mortgage payments was at a 20-year high at 5.59%. Payments are considered delinquent if they are 30-days or more past due.

While subprime adjustable rate mortgages only represented 6.8% of the loans outstanding, they represented 43% of the foreclosures during the third quarter, the MBA reported.

The markets were up Thursday morning in anticipation of the deal’s announcement. Afterward, the market more than doubled the gains already made. No surprise, the financial sector performed well, with Countrywide Financial Corp. (CFC) jumping more than 19% on the day. 

What Happened…

The deal comes on the heels of a severe six months for lenders, starting with the subprime market crumbling when borrowers couldn’t afford to make mortgage payments.
This triggered the larger financial fallout because the mortgages were packaged and resold to investors around the world.

Banks were stuck writing down debt, which in turn made securing credit tough for homebuyers because of tighter lending standards. 

Though few banks went under, many announced massive write downs, cut more than 130,000 employees and suffered double-digit profit losses.
Countrywide was the financial sector’s poster child of pain caused by the woeful credit market. During the third quarter, Countrywide:

• Announced the departure of 10,000 to 12,000 employees.
• Received a $2 billion capital injection from Bank of America Corp. (BAC).
• Watched one of its largest shareholders, AXA SA (AXA), cut its company stake from 11% to 4.1%.
• Was investigated by the Securities and Exchange Commission about Chief Executive Angelo Mozilo’s conspicuous stock sales before the mortgage bubble burst in July.

Countrywide also reported a third-quarter loss of $1.2 billion (or $2.12 a share), compared to a profit of $647.6 million (or $1.03 a share) for the same quarter last year – marking the company’s first quarterly loss in 25 years.

Additionally, a number of top financial-services companies recorded massive declines in third-quarter profit. For instance, profits declined:

• 57% at Citigroup
• 61% at The Bear Stearns Cos. Inc.(BSC).
• 17% at Morgan Stanley (MS).
• And 10% at Wachovia Corp. (WB).

… And How Will Investors React?

While this deal scored well across the political board, the largest contingency of cynics is investors.

Businessweek reports that investors in mortgages or mortgage-backed securities – who already took a beating this year – are likely to take another hit if the plan passes because homeowners will pay less on their mortgages than originally planned. 

"The $64,000 question remains: will investors who might balk at going along with this be able to maintain legal roadblocks and prevent the plan from going into effect?" Sen. Charles Schumer, D-N.Y. told the Associated Press.

However, bigger costs incur when a mortgage is foreclosed so this is the best scenario for investors, homeowners and banks, the AP reported. 

News and Related Story Links:

• Money Morning:
  Citigroup: Why This Turnaround Play Has Legs – Big Ones

• Bloomberg:
  Bush Aims to Prolong Expansion With Subprime Freeze

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

• Businessweek:
  What the Mortgage Bailout Means For You

• Associated Press:
  Bush moves to help on mortgage rates

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."]

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:
  Avoid the ‘Resurgent’ Homebuilding Sector and Go Global for Profits.

• Money Morning:
  Housing Market Down For the Count, According to Industry Experts.

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

• Money Morning:
  Banks Create Fund to Help to Fight Woeful Credit Market.

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

• USA Today:
  Investors cheer UBS, Citigroup write-downs.

• Bloomberg:
  Merrill Lynch Reports Loss on $8.4 Billion Writedown