WEST PALM BEACH, Fla. — Anyone paying attention to the bond market these days is worried about the signals it is sending about the economy. With one eye on the bond market and the other on the Federal Reserve, investment analysts are wondering if Fed Chairman Ben Bernanke will break with previously released statements and again lower the funds rate at its next meeting. If analysts had a Third Eye, it's likely watching the stock market, which is reacting to those other markers, earnings reports, oil and gas prices, consumer confidence (way down) and Christmas spending predictions (way down, too).

Just when experts and Wall Streeters think they've seen the bottom of the subprime barrel another load of bad apples turns up. Merrill Lynch said recently that it would take an additional $3 billion-plus charge-off for mortgage-related securities over the announced $5 billion it expected to write off only weeks earlier making a total of $8.4 billion. Exit CEO E. Stanley O'Neill. Then Citgroup took its biggest write-down, $10 billion in late October. Exit CEO Charles Prince.

The culprit was collateralized debt obligations, or CDOs, pools of securities backed by mortgages. Investment banks slice and dice CDOs into pieces and sell them to investors. To the subprime buyers go the highest yields.

The National Association of Realtors (NAR) showed sales of existing homes in September fell twice as far much as expected to the lowest level in 10 years. With the market on a roller coaster, investors are fleeing to safety, buying government Treasuries. The prediction for the total cost of the mortgage meltdown is $400 billion. The closest measuring stick in recent times is the Savings and Loan bailout, and its $240 billion pales in comparison.

Help may be on the way for some homeowners, as Congress is working on several bills to address mortgage related problems. And the states are active as well. New York Gov. Eliot Spitzer recently asked the financial services industry to create a fund to help mortgage-backed securities rewrite mortgages that may avoid home foreclosures. He also wants the “ability to repay” included in any planned legislation.

Homeowners can't borrow against the equity in his house any more because values have declined steeply, and that spells trouble for the malls of America. How much wealth will disappear? Estimates vary, but the range is put at between $2 -$4 trillion. How does that compare with the losses in the stock market tech crash that opened the millennium? That was a whopping $7 trillion. It's still early yet, though, and analysts are suddenly cautious about whether the mortgage downturn has hit bottom. Despite the investor boom of the late nineties, which saw everyone buying mutual funds and the sudden popularity of day-trading one's way to making the first million, the real depth of it was overblown. Maybe this home value whirlpool will prove similarly overheated, but one thing is for sure: more Americans own homes now than were active stock players then, making the pain more widespread. And because home equity was the push behind spending, its withering away could mean the “R” for recession word will be the next hot topic on business news sites and cable TV programs.

CNBS reported in its Food for Thought for the week of Nov. 12th that Freddie Mac reported that while the “share of refis for cash-out purposes increased in the third quarter, the dollar volume of cashed-out equity declined to $60.1B from $81.4B in the second quarter–probably due to less equity to pull from the homes. Freddie also reported that the median rate for the refinanced loans was about 62 basis points higher than the original loan, and that 87% of the loans had a balance at least 5% higher than the original mortgage – all potential signs of overall credit problems among those borrowers …” At Fannie Mae, a larger-than-expected third-quarter loss of $1.39 billion was reported.

With the ten-year Treasury yield down slightly, it isn't likely that first mortgage applications are going to rise, leaving the business action to refinancings as ARMs reset, credit union brokerage firm CNBS predicted. In the next 18 months, more than two million ARMs will reset.

Foreclosure Prediction

The Joint Economic Committee of Congress predicted about two million foreclosures by the end of 2008 for the subprime sector. And foreclosures in a neighborhood usually sink prices further. The second wave of hurt (the first is lost jobs in construction and related suppliers) comes from the loss of property taxes, with cities, counties and municipalities shrinking everything from police and water to road services.

States hardest hit are expected to be the ones where the boom was loudest, like Florida, California (hurting already from severe fire catastrophes) to the Midwest, like Michigan (with Detroit automakers laying off employees) and Ohio.

Dose of Reality?

Many banks, including Countrywide, Bank of America and others have already announced a return to old fashioned underwriting standards. Credit unions, with a few recent exceptions (Cal State 9, Norlarco, Huron River Area) haven't strayed too deep in the high-risk lending arena and for the most part escaped the bad news cycle.

The Financial Accounting Standards Board's (FASB) new rule for accounting practices Statement 157 went into effect on Nov. 15. That rule requires firms to place assets into three distinct categories that have innocent-sounding names: Level 1, 2 and 3. The first simply refers to assets that can be marked-to-market, where its worth is based on something real, like a stock price. Level 2 is mark-to-model, where no price is available and bids for them are averaged to arrive at a price. Level 3 is sheer guesswork.

The new rule means that banks will be required to show how much of each they have in their portfolio. And that could be a problem if there's more guesswork than confidence in the credit markets. So it's possible that final quarter write-downs may be in the offing.

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