Real Estate Problems Are Not Contained

There were at least two real estate items on Wednesday that deserve mention this evening. The first is the existing home sales which showed an 8% drop from the last month. The stock market fell a little harder just after that news was released. It was almost like the market was going to connect the dots but more about that later.

The other event was Merrill Lynch's earnings announcement...ouch. About a month ago, the company said it would have to write down some of its mortgage debt holdings. In a Fortune article reported on CNN Money, the company had said it would write down about $4.5 billion but when it announced on Wednesday, it actually ended up writing down close to $8 billion.

The WSJ is indicating there will be a front page article on the Merrill earnings situation in Thursday's edition. The article has essentially the same information as the article above.

According to another source, Merrill had to reduce the value of some super-senior subprime assets. According to that source, this debt is normally rated AAA with a plus sign. With this new valuation level, Merrill has sort of "lowered the bar" on the value of these assets which are held by numerous other entities. What this means for them will be determined in the very near future.

Merrill said that it had been conservative in setting the value of these assets but when asked about how many other assets were not marked to a market price, there was not much in the way of an answer. So, it seems that the triple A debt described above was actually never really marked to market but marked to model and now the model is being adjusted to reflect the new subprime reality.

In a related story from Wednesday's WSJ, Countrywide is back in the news once again. Apparently, there is another leak that has sprung on one of its asset categories, that being the option ARM in the prime market place. What was that? Did you say Prime? Why, yes, we did.

You remember the option ARM, the one that allows you to pay less than the full interest payment on the loan. This mortgage is the so called "neg-am" loan, meaning negative amortization loan. What that really means is that the principal is going up on the mortgage. Now, this concept worked pretty well as home prices were rising because home buyers could easily sell or refinance their homes anytime it was necessary. Those days are now over.

Now, credit is more difficult to come by and neg-am is almost a memory but it is still a bad dream for both ends, for people who bought more house than they could afford by getting an option ARM and for investors who now aren't getting principal payments and are having to mark down their assets.

Anyway, CFC has disclosed that there may be a problem with the prime option ARMs as far as the defaults are concerned. This was documented in the aforementioned WSJ article on Wednesday and probably was responsible for the drop in CFC's stock. The stock was down $1.22 to $13.83. We would really enjoy copying the entire article here but the WSJ may frown on that. We highly recommend this article because it has some great facts that you would enjoy.

Some of them include the CEO, Angelo Mozilo, commenting on how he was "shocked" that so many borrowers were making the minimum payment on their loans. The article says he called some borrowers and found out that people said the value of their homes were going up at a faster rate than the neg-am.

The article says that a borrower with a 6.05% $520K fixed rate mortgage would pay $3,134 a month but with an option ARM at 1% the payment drops to $1,673. But, after five years the borrowers need to start repaying principal and meeting full interest payments causing payments to more than double above the fixed rate payment. Another problem is that there is a maximum overage the loan will allow, such as 110% to 125% before principal payments kick in.

We were a little surprised that the market was able to swallow all of this news and then recover from the 200 point loss at midsession. The technical side of this suggests that the late day rally is simple a wave C, which is an ending wave leading to a selloff. The selloff could be fairly large but there is a chance that it will only be a corrective wave...again. We will comment on it as we see how far down this can go. We expect 13K in the Dow before we have to make any real decisions.

Speaking of decisions, the Fed will have to make one by next Wednesday. Yes, we are speaking of the next rate decision due then. As we have said several times before, the Fed doesn't set rates, it follows the market. So, what is the market saying? Well, the 3 month T-bill hasn't traded above 4.25% in October and now sits at 3.85%. This rate would suggest the Fed could actually lower rates at least a half point next week. We don't think they really want to push too hard on that 4.25% October high so we would call for a 25 bps drop tonight. If things get weaker in the T-bill world, we might be pushing on another 50 bps. The market will be interested in the decision but it may not actually like another 50 bps.