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Tuesday, August 26, 2008

3 Wood: House of the Falling Stock

The Prophet Zimmy ~ House of the Rising Sun

The recent volatility in the stock market is due to continued doubts about housing prices.

U.S. stock futures edge lower after volatile sessions

"LONDON (MarketWatch) -- U.S. stock futures edged lower on Tuesday after the last two volatile, low-volume sessions, with traders waiting for three reports on housing to hunt for clues as to whether the long-battered market is showing any sign of recovery."

Now, here is the crucial part:

"The inventories in the new home sales data will be closely watched as yesterday's better-than-expected existing home sales were offset by a sizable increase in inventories as foreclosures flooded the market," said Jim Reid, a strategist at Deutsche Bank.

"Prices are not going to stabilize while such a trend is occurring. This in turn doesn't help us find a bottom in the pricing of any security based on U.S. property and doesn't help us find the end of the bank write-downs, which doesn't help confidence in the financial sector or system generally."

It all boils down to the fact that when you have securities that are backed by mortgages, things are fine as long as property prices are stable or rising. But when property values are dropping, you have no real bottom on the value of the security. That causes a lot more risk which in turn causes market volatility. Think of it as one large game of musical chairs with various investors afraid of being caught without a safe place to sit.
~ 3 WOOD

The focus in the market is turning back to Freddy Mac and Fannie May, and the reasons are a little vague.

Forgetting Freddie (and Fannie)

"NEW YORK (MarketWatch) -- Financial bailouts are supposed to save institutions. So why does the imminent takeover of Freddie Mac and Fannie Mae seem like a Russian peacekeeping mission in Georgia?"Just based on the raw numbers, this shouldn't be happening.

Fannie and Freddie barely touched the subprime and Alt-A loans that have been blamed for so much of the credit crisis. And while many homeowners are hurting, the number of defaulted loans is about 2%, less than half of the rate in the great S&L crisis, according to the Federal Deposit Insurance Corp. That's industry-wide, not at the GSEs where lending standards are much higher.

So, even though logic says this shouldn't be happening, it is. The idea of Fannie and Freddie going the distance is something we need to let go of. Yankee fans should understand."

I think what is happening is the market is getting shell shocked from the ongoing parade of bad news, and starting to assume the worst will happen at any given time now. While the impact of bad loans on Fannie and Freddy is slight at this time, the problem you have is each mortgage is like a ticking time bomb where a good loan today can go bad tomorrow. You just do not know for sure what the status of a given loan is from one day to the next. So the risk factor skyrockets.

In essence, the cost of assuming risk has greatly increased in the market over the last 6 to 9 months. Since the rate of return is not there to compensate for all that higher cost risk, the liquidity is dropping out of the market and things keep slowing down. I still think that Fannie and Freddie are solid. But the both of them will probably need some ongoing support from the Fed's before confidence starts regenerating in the system.
~ 3 WOOD