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Generational Dynamics Web Log for 26-Oct-07
Near total collapse of ABX index shows that mortgage problems continue to grow

Web Log - October, 2007

Near total collapse of ABX index shows that mortgage problems continue to grow

On a day when the Bank of England warned investors that the stock market is "particularly vulnerable," the ABX-HE index continued to fall like a stone, indicating that the market values of CDOs in many institutions' portfolios are continuing to fall as well.


Prices of ABX-HE series 07-2 for various risk levels on 25-Oct-2007 <font face=Arial size=-2>(Source: Markit.com)</font>
Prices of ABX-HE series 07-2 for various risk levels on 25-Oct-2007 (Source: Markit.com)

This came on the day when the Bank of England issued the semi-annual Financial Stability Report. The report said that the global financial system is at risk of further instability because of "ongoing uncertainties" about credit-market losses, and that both the stock market and commercial real estate values are particularly vulnerable to "further shocks, either in credit markets or from new sources." The gloomy outlook was confirmed in testimony by Chancellor of the Exchequer Alistair Darling.

None of this affected investors, of course. Speaking from the floor of the New York Stock Exchange, CNBC commentator Bob Pisani said that "investors are obsessed with a Fed rate cut next week. That's all they think about. That's all that matters to them."

The ABX-HE indexes are a measure of investor confidence that homeowners are not going to default on their mortgages. The three graphs shown above reflect mortgages that were granted this year, from January 1 to July 1, 2007. The top level graph represents the highest quality prime mortgages, with rating AAA or AA; the middle level graph represents medium risk Alt-A mortgages, with rating A; and the bottom graph represents highest risk subprime mortgages. Indexes at all levels are falling like rocks, and may be headed to zero.

The ABX indexes are proxies for the "market values" of mortgage-backed CDOs in the portfolios of Merrill Lynch and other financial institutions.

Who knows? Maybe one of the reasons that Merrill had to write down $7.9 billion in CDO values, instead of the $4.5 billion they had told us just two weeks ago, is because the ABX indexes fell sharply in the interim.

I like to look at trends, so let's take a look at the trends that have gotten us to the current place:

I wanted to give this summary just to show that the mainstream financial media and pundits will always put the best spin on things. They are, in effect, biased in the direction of keeping the bubble growing as long as possible, even though the larger the bubble, the greater the disaster when it finally bursts completely.

The continued collapse of the ABX index values is really bad news, because it means that the CDOs and other securities in the portfolios of financial institutions are becoming more and more worthless every day.

CNBC commentator David Faber made an interesting point on Thursday. He said that "Merrill Lynch wrote down its high-grade CDOs by 19%, and its [low-grade] CDOs-Squared by 57%." He then compared this to what a small investment firm, Ambex has done. "By contrast, the mark-to-market losses announced by Ambex on its CDO portfolio, which is made up of exactly the same stuff that Merrill had in its portfolio, stand at 2%."

Faber's comment makes it clear that Ambex has a long way to go in writing down the values of its securities, and by implication so does almost everyone else. Even Merrill, in making its announcement on Wednesday, said that it might have further writedowns on the same securities.

How long can these firms keep this up? How long can they hide the fact that their CDOs are worth far less than they're telling us? How long can they resort to SIVs and M-LECs and Super-SIVs that allow banks to sell worthless securities to each other at inflated prices in order to establish a phony "market value" for the worthless securities?

My instincts tell me that this can't possibly go on much longer, but let's face it, my timing instincts haven't always been the best. But at some point there'll be a "tipping point" and a panic, when it becomes clear that the global financial system is built on top of these near-worthless securities. This panic might occur next week or next month or even next year, but I just can see how it can be prevented much longer.

Let's just review what we do know.

As I showed in my article, "How to compute the 'real value' of the stock market," the stock market is overpriced by a factor of 250%, same as in 1929.

One of the graphs from that article is the following:


S&P 500 Price/Earnings Ratio (P/E1) 1871-2007
S&P 500 Price/Earnings Ratio (P/E1) 1871-2007

Now, no one in his right mind can look at this graph and not see immediately that the stock market is going to crash. The P/E ratio will drop below 10, as it did in 1982, for example, and the stock market will fall to Dow 4000 or lower.

From the point of view of Generational Dynamics, we're headed for a generational panic and crash with 100% certainly. (26-Oct-07) Permanent Link
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