Bernanke's Speech - No Cure for SubPrime Market Melanoma

Bernanke's Speech - No Cure for SubPrime Market Melanoma

If you expected the announcement of a Fed Funds rate cut, you are probably a
disappointed residential housing speculator. If you expected some straight talk
about the mortgage backed securities mess, you are likely to be a somewhat
satisfied investor or trader.

What you may have missed is the ongoing reality expressed in recent data, such
as GDP, Jobless Claims, Personal Income/Expense, NAPM, Factory Orders
and Consumer Sentiment/Confidence.

In my view, these data reflect what we have been stating to readers throughout
this "credit crisis". The stock market's downturn is a normal correction in a Bull
market. It's not the beginning of a depression or recession. It sure could be if
the Street doesn't or isn't willing to take the cure.

Nothing has changed dramatically in Peoria.

It's still pretty normal out here, beginning 50 miles away from lower Manhattan.
We still have low unemployment, the consumer is still spending at a normal pace,
businesses are ordering goods and services, and replacement capital goods.
Kids are back in school and gasoline is still affordable for the SUV.

The credit crunch exists with the community of irresponsible lenders and
borrowers in residential real estate, and their cousins in the collateralized debt
markets. Only a small section of the whole residential market is under pressure.
It is predominantly contained and originated in the recent hot real estate markets
(or formerly boom markets) of California and Florida. The boom markets
became obviously "former boom" markets by mid-2006.

Everybody Loves a Boom

The booms began in 2002 and attracted the national builders and developers
like moths to a lantern on a starless night. Close behind them were the anxious
speculators with bulging credit lines to use to buy 5, 10 and 20 or more houses
before the first foundation was set in. The speculators would "flip" the houses
for a handsome profit and then move on to the next new residential gold mine,
following the builders.

The banks loved the high fees and the high interest rates paid by developers,
builders and speculators. In turn, the developers and builders loved the loose
and abundant credit available. The speculators grew in numbers quite rapidly as
consumers seemed to continually demand new houses. It was a true love fest
that eventually festered when they exhausted the demand for houses and
condos.

Nobody knows what to do at Boom's End

Existing houses rose rapidly in price as the speculators pushed prices higher and
higher each year for new houses. Homeowners were encouraged to load up
their newly found potluck of home equity with added higher interest rate
debt on their homes. Remember those offers of 125% home equity loans
arriving in the daily post?

A self-feeding and self-fulfilling cycle of a parabolic boom is what happened.
When the boom begins to slow, none of the participants can stop themselves.
They are fully addicted and blinded to any sane reason to stop. Just "Buy! Buy!
Buy!" Nothing new under the sun at this point. It's a boom that will never end,
right.

What's new and different in this real estate boom?

Non-conforming loans are not new, nor illegal, nor immoral. They have always
been a small fragment of the residential market. In the late 1990's,
non-conforming loans, or what is now called Sub-Prime Mortgages, became de
riguer for banks, investment houses and private equity groups who wanted more
interest income, and the grand fat fees that accompany these lending facilities.
Bank of America, Citigroup and Deutsche Bank were just a few of the major
demigods of this creativity in the mortgage market.

As all conforming mortgages are bundled together for investors to buy into the
future stream of payments, the "safe" rate of return (Americans are notorious for
paying their home mortgages) was not so safe in the sub-prime bundled
mortgage arena as it turns out. Isn't that how sub-prime is defined?

When does it make good sense to buy "sub-prime" beef or a "sub-prime" car?
It only makes sense when you can convince yourself and the guy who wants to
buy it that it's just as good as prime beef or a prime new car.

Demigods create the exotics

Meanwhile back at Reality Ranch, Wall Street investment houses and banks
used their creativity to birth all sorts of derivative investment vehicles out of the
bundled mortgage and other debt magma. What evolved from these creative
juices is now just generally called 'mortgage-backed securities' which is today's
lead balloon in the much larger category of exotic investments, called
"Collateralized Debt Obligations" or CDO's. It takes a Ph.D. in mathematics to
understand some of these exotic instruments. An entry-level math Ph.D. starts
at about $400,000 a year on Wall Street.

The prices of these convoluted instruments were set by a highly specialized
marketplace. It is even more specialized than you think because the creators
also made the market (set daily prices) in the CDO market.

So when a buyer, like a mutual fund or a pension fund wanted to buy some,
they got the creators price. After they owned it awhile and wanted to sell it,
they got the creators price. Great deal for the creators isn't it.

The problem is a pimple that became acne, but was really a melanoma.

It's all about the flow of money in and out of this CDO market. "More Liquidity
please!" cried the market. "Somebody please buy my beautiful junk!" screamed
the vendors. "How much do you want for it? How much is it worth?" asked
the investor. Quietly, almost sub-sonic, the vendor muttered, "I have no idea."
Sensing a potential bargain, the investor asks, "When will you know how much
it's worth?" The vendor glances up at the investors with one eye, "When you
buy it?"

The investor says he might be back, but he wants to check with a few others
first. The vendor calls out to the investor walking away, "Nobody else knows
what any of this stuff is worth either." And then adds with a sigh, "We just
need some liquidity."

The Liquidity Cure

The needed liquidity must come from the market master surgeon. Melanomas
aren't treated any other way but with excision. Cut it out, and cut fast. If it
recurs, the market surgeon will carve deeper and wider.

Governments have no cure for this but they do have a more disastrous solution.
A bailout. That's the non-surgical "two aspirin and call me in the morning"
prescription or, in this case, their cure for the cancer.

Bernanke, Dodd, Clinton and Bush - No surgeons allowed!

None of them have the cure. Bernanke knows and understands the problem,
but he's a Ph.D. doctor, not the market's surgeon.

Dodd knows Congress can't fix it. But if Congress can't fix it, he could still
get some good TV coverage for his presidential bid with a Congressional
hearing and investigation.

The Sen. Clinton promise of a bailout shows she predictably wants to be the
governmental WalMart, who will refund your money for that half eaten apple.

President Bush wants to help those who can help themselves, but don't need
help. They aren't in trouble with their FHA/VA loans.

The Unilateral Solution

Simply, let the buyers and sellers in the CDO market sort it out. Most of that
market trades in quality debt obligations from quality corporations and
governments. It is a critical part of the day-to-day financial marketplace. The
players in that market must clean their own houses of the rotting securities in
their inventory.

They say they don't know what's good and what's not so good and what's rotten.
Sort through them until you find the rotten fish. The whole pile is not rotten,
just the few that smell. The longer they wait and complain, the greater the
festering smell from the spreading melanoma in their kettle of fish.

It will be painful for them and the investors in those securities. But that's the
choice: radical surgery or live with the smell of your own necrosis.

Save the patient by excising the cancer. Now!

Or, kill the patient by seeking sympathy by complaining about the pain, and
re-telling the story about the pimple that grew into a melonoma. All you will get
are Hallmark sympathy cards with the a "Get Well" wish or the proverbial,
"Sorry for your loss."

How does the story end?

The CDO market struggles, then stock markets drop dramatically which forces the
needed re-pricing of assets in the CDO general market. Don't forget that there is always
somebody willing to buy a distressed asset. A few days ago, Warren Buffet was willing
to buy the troubled assets of Countrywide Financial for 25 cents on the dollar wasn't he.

Lower the price enough in a melanoma market and you will find your cure.

W. B. Busin Intraday Monday, August 27, 2007

1500 EDT


The formation and technicals for the NDX and Dow are showing a difference
with SPX and RUT.


The SPX/RUT are exhibiting weakness while the Dow/NDX are showing
signals that may produce an upward move from this time toward the closing.
The move may include higher highs than Friday's closing high. This is just a
potential for intraday traders and Swing traders.


We expect a similar narrow trading spread for tomorrow's morning session.
The downward bias to tomorrow's action should be more evident than today's.
If price does not begin to decline with more momentum, we may be incorrect
for the direction.


In general, we expect the market to retest near the recent lows as a any fine
correction will do. We are still monitoring the parallel to the 1998 correction
and its time variance. The time variance may be quite large with the aggressive
intervention by Chairman Bernanke and the New York and San Francisco
Fed's.


It may have shortened the entire correction by weeks. In 1998, Greenspan did
not intervene until mid-September and then aggressively after the correction was
over in October.


I have said that I do prefer Chairman Bernanke much more than Greenspan.
What he has done and not done are equally important. If as we expect, the
economy is slogging along at a more moderate pace (not crashing into
recession), then all the better.



If so, the Fed Funds rate should be left where it is. Fed Funds will likely rise in months ahead before it is reduced by the FOMC. To clip the 1992 Clinton campaign slogan, "It's the economy, stupid." seems appropriate at this point in the correction.


It's evident that the financial world did not collapse and we are not plunging into
the next Great Depression are we. (A few "Woe is me!" economists may wish
us the worst, but again, they are wrong.) The correction is not over in our view
but the lows may be set in for some of the indexes. Further declines should
appear in the next few weeks.


A positive conclusion about the correction is that it has been a healthy orderly
decline. The opportunity to find blue chip mutual funds and/or stocks for the
coming rise is a fine gift from the market. We would begin looking for stocks
bottoming early that are in the blue chip category. We continue to believe that
Dow stocks and other blue chip technology stocks will outperform in the next
move upward.



WBB
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