WEST PALM BEACH, Fla. — Anyone paying attention to the bondmarket these days is worried about the signals it is sending aboutthe economy. With one eye on the bond market and the other on theFederal Reserve, investment analysts are wondering if Fed ChairmanBen Bernanke will break with previously released statements andagain lower the funds rate at its next meeting. If analysts had aThird Eye, it's likely watching the stock market, which is reactingto 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 thebottom of the subprime barrel another load of bad apples turns up.Merrill Lynch said recently that it would take an additional $3billion-plus charge-off for mortgage-related securities over theannounced $5 billion it expected to write off only weeks earliermaking a total of $8.4 billion. Exit CEO E. Stanley O'Neill. ThenCitgroup took its biggest write-down, $10 billion in late October.Exit CEO Charles Prince.

The culprit was collateralized debt obligations, or CDOs, poolsof securities backed by mortgages. Investment banks slice and diceCDOs into pieces and sell them to investors. To the subprime buyersgo the highest yields.

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

Help may be on the way for some homeowners, as Congress isworking on several bills to address mortgage related problems. Andthe states are active as well. New York Gov. Eliot Spitzer recentlyasked the financial services industry to create a fund to helpmortgage-backed securities rewrite mortgages that may avoid homeforeclosures. He also wants the “ability to repay” included in anyplanned legislation.

Homeowners can't borrow against the equity in his house any morebecause values have declined steeply, and that spells trouble forthe malls of America. How much wealth will disappear? Estimatesvary, but the range is put at between $2 -$4 trillion. How doesthat compare with the losses in the stock market tech crash thatopened the millennium? That was a whopping $7 trillion. It's stillearly yet, though, and analysts are suddenly cautious about whetherthe mortgage downturn has hit bottom. Despite the investor boom ofthe late nineties, which saw everyone buying mutual funds and thesudden popularity of day-trading one's way to making the firstmillion, the real depth of it was overblown. Maybe this home valuewhirlpool will prove similarly overheated, but one thing is forsure: more Americans own homes now than were active stock playersthen, making the pain more widespread. And because home equity wasthe push behind spending, its withering away could mean the “R” forrecession word will be the next hot topic on business news sitesand cable TV programs.

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

With the ten-year Treasury yield down slightly, it isn't likelythat first mortgage applications are going to rise, leaving thebusiness action to refinancings as ARMs reset, credit unionbrokerage firm CNBS predicted. In the next 18 months, more than twomillion ARMs will reset.

Foreclosure Prediction

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

States hardest hit are expected to be the ones where the boomwas loudest, like Florida, California (hurting already from severefire catastrophes) to the Midwest, like Michigan (with Detroitautomakers laying off employees) and Ohio.

Dose of Reality?

Many banks, including Countrywide, Bank of America and othershave already announced a return to old fashioned underwritingstandards. Credit unions, with a few recent exceptions (Cal State9, Norlarco, Huron River Area) haven't strayed too deep in thehigh-risk lending arena and for the most part escaped the bad newscycle.

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

The new rule means that banks will be required to show how muchof each they have in their portfolio. And that could be a problemif there's more guesswork than confidence in the credit markets. Soit's possible that final quarter write-downs may be in theoffing.

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