The Level 3 Bomb

Today, the Dow Jones dropped by 2.6% (or 360 points), so you'll have the usual talk about volatile markets, and the just as usual dismissals that the Dow is just a few percent off its all time high. But what's happening in the credit markets, and on the balance sheets of the banks is in fact a lot more worrying. In particular, smart players are now focusing on so-called 'Level 3' assets. And they are, there is no other word for it, panicking. Let me take you through it.
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Financials Drag on Markets

Banks and Wall Street brokerage stocks once again dragged the broader stock market lower Wednesday, in a reflection of how credit-market concerns are still driving markets as investors also cope with a weak dollar and record oil prices. Stocks started the day weak, but selling accelerated around midday, and major benchmarks finished near their lows for the session. The Dow Jones Industrial Average tumbled 360.92 points to 13300.02, wiping out all the gains since the Fed's first rate cut September 18. The S&P 500 sagged 44.65 points to 1475.62, while the Nasdaq Composite Index shed 76.42 points to slide to 2748.76. 'There is nowhere to hide,' says Jack Ablin, chief investment officer at Harris N.A. He said that the sell-off of the financials reflects a 'continual spiraling of the credit crisis' due to lack of adequate disclosure. 'We are facing a tropical storm: we know it will hit, but nobody knows how serious it will be,' he said.
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Banks Face $100 Billion of Writedowns on Level 3 Rule

"(Bloomberg) -- U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc. The Financial Accounting Standards Board's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's chief credit strategist Bob Janjuah in London wrote in a note today. The new rule is effective Nov. 15. ``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' Janjuah said. ``The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark- to-make believe.'"
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Bear CEO's handling of crisis raises issues

Bear Stearns CEO James Cayne was out of the office playing bridge and golf on critical days this summer, while two of the company's hedge funds faced turmoil.
Kate Kelly, Wall Street Journal
01 Nov 2007 05:52

A crisis at Bear Stearns Cos. this summer came to a head in July. Two Bear hedge funds were hemorrhaging value. Investors were clamoring to get their money back. Lenders to the funds were demanding more collateral. Eventually, both funds collapsed.

During 10 critical days of this crisis -- one of the worst in the securities firm's 84-year history -- Bear's chief executive wasn't near his Wall Street office. James Cayne was playing in a bridge tournament in Nashville, Tenn., without a cellphone or an email device. In one closely watched competition, his team placed in the top third.

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Countrywide's New Scare 'Option ARM' Delinquencies Bleed Into Profitable Prime Mortgages

Subprime mortgages aren't the only challenge facing Countrywide Financial Corp., the nation's biggest home-mortgage lender. Some loans classified as prime when they were originated are now going bad at a rapid pace.

These loans are known as option adjustable-rate mortgages, or option ARMs. They typically have low introductory rates and allow minimal payments in the early years of the mortgage. Multiple payment choices include a minimum payment that covers none of the principal and only part of the interest normally due. If borrowers choose that minimum payment, their loan balances grow -- a phenomenon known as "negative amortization."

Countrywide first offered these loans in 2003 and quickly became a leader in this profitable and growing part of the mortgage market. Mortgage brokers liked the higher commissions and borrowers were drawn to low payments. As lending standards loosened, more of these loans included less-than-full documentation

ARM MONSTER
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The News: At Countrywide (under Angelo Mozilo, above), delinquencies are rising for option adjustable-rate mortgages, which carry low introductory rates but can lead to a rising loan balance.

Background: Lax lending standards led to rising subprime delinquencies. There are signs of similar woes in the prime sector.

Worst to Come? In 2009-2011, monthly payments on $229 billion of option ARMs will readjust (so borrowers may have to pay more).

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http://online.wsj.com/article/SB119318489086669202.html?mod=US-Business-News

Merrill Lynch Posts Wide Loss

NEW YORK -- Merrill Lynch & Co. swung to an unexpectedly deep loss in the third quarter on the back of a $7.9 billion writedown in its fixed-income trading business, a hit that exceeded the Wall Street giant's net earnings for all of 2006.

Merrill posted a net loss of $2.24 billion, or $2.82 a share, well beyond the damage the bank forecast in an Oct. 5 earnings warning. At that time, it expected a loss of up to 50 cents a share after writing down $4.5 billion of subprime mortgages and collateralized debt obligations. The actual loss on those positions came in $3.4 billion higher after market values were re-examined and more conservative assumptions were applied in the intervening two and a half weeks, Merrill said.

http://online.wsj.com/article/SB119321271755269627.html?mod=hpp_us_whats_news

U.S. Economy: Existing Home Sales Tumble 8 Percent

Oct. 24 (Bloomberg) -- The U.S. housing industry plunged deeper into recession last month as the August credit-market collapse made it harder for buyers to obtain loans.

Sales of previously owned homes fell 8 percent in September to an annual rate of 5.04 million, the fewest since records began in 1999, the National Association of Realtors said in Washington. The decline was almost twice as steep as economists forecast, while the median price dropped the most in almost a year.

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http://www.bloomberg.com/apps/news?pid=20601087&sid=aW5GnFnGiKj8

Get Ready for the Big Squeeze

THE big banks that reported earnings last week made clear that the days of fat profits are over. Now the questions are these: How long will the lean times last, and what will they do to banks’ earnings and stock prices in the future?

After last week’s earnings announcements, financial services stocks took a dive. The Russell 1000 Financial Services index lost 7.2 percent of its value for the week.

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The Gloomsayers Should Look Up

BEFORE I start on this little tour d’horizon, I just want to say that a good, fresh Taco Supreme from Taco Bell is more tasty than just about anything at any fancy-pants restaurant anywhere in the world. And they didn’t pay me, and they don’t even know me. Just for perspective.

And really, the whole story about the economy, credit, morality and rescues is about perspective. Start with the good news about perspective: The economy is basically in fine shape. Not perfect, but darned good. Almost all mortgages are not in default. Almost all workers in the labor force who care to work are not unemployed. The largest percentage ever of American household units, what were called "families" in the old days, own their own homes.

The stock market, in both absolute terms (the number on the Dow) and relative terms (the relationship of price to earnings), reflects optimism and an extraordinary, robust level of profits.

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Mortgage Security Bondholders Facing a Cutoff of Interest Payments

For all the pain in the mortgage market, investors who hold bonds backed by risky home loans have continued to receive their monthly interest payments until now.
Collateralized debt obligations made up of bonds backed by thousands of subprime home loans are starting to shut off cash payments to investors in lower-rated bonds as credit-rating agencies downgrade the securities they own, according to analysts and industry executives.

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Banks’ Plan to Help May Itself Need Help

Does the rescue plan for the credit markets need to be saved?

The plan is still being developed, but the roughly $75 billion effort to snap up troubled securities is struggling to get off the ground, days after it was disclosed by the country’s three biggest banks with the support of the Treasury Department................

"This is just taking money from one pocket and putting it another, with admittedly slightly stronger credit backing," said William H. Gross, the chief investment officer of Pimco, the huge bond manager.

Mr. Gross, whose firm manages about $700 billion in assets but does not hold asset-backed commercial paper issued by S.I.V.’s, said the situation reminded him of Japanese banks that refused to sell or write off troubled loans at distressed prices in the 1990s. Then, United States Treasury officials advised their counterparts in Japan to move swiftly to clear their portfolios of problem debts. Today, Treasury officials are doing the opposite, he added.

"They are refusing to liquidate assets at market levels, so the problem continues," Mr. Gross said in a telephone interview yesterday. "Let’s get this stuff out in the open and find out what the assets are worth."
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