What's Behind the Dow's Swan Dive ...

By: Money_and_Markets

Mike Larson writes : Let's not mince words. This week has been simply awful for the Dow.  The Industrials plunged 226 points on Tuesday alone, put in an anemic bounce Wednesday, then sank another 311 yesterday. The carnage was even worse in several sectors I've flagged for months — home builders, financials, commercial REITs and more.

What's going on? What's behind this swan dive? Well, investors can be fickle:

When the easy money is flowing, volatility is low, and there's hardly a financial wave on the horizon, bond investors will buy just about anything. It doesn't matter if it's super high-risk mortgage bonds … the junkiest junk debt … or complex collateralized debt obligations that even a room full of finance professors can't understand.

That enthusiasm carries over to the equity markets, too. After all, you never know when the next easy money-fueled acquisition will send another stock soaring. The result: Everyone feels comfortable loading up their portfolios with speculative shares.

Up until a few short months ago, that's exactly what was happening. The bond sharks were going crazy with all that financial chum, buying every last bit of debt they could sink their teeth into. And stock indexes were making new highs. [Editor's Note: See Mike's November 17, 2006 piece titled " Money, Money Everywhere ."]

Now, the Seas Are Choppy and The Skies Are Pitch Black!

Several months ago, I alerted you to important changes going on in the mortgage debt market. I said,

"More and more average Americans are struggling to pay back record levels of debt. Many are just giving up. This will drive loan losses up throughout the mortgage and banking industries — it's just a question of magnitude.

"My guess is you're going to see weaker lenders and home builders fold."

The earliest casualties were just emerging at the time. One firm called Ownit Mortgage Solutions — the 11th largest subprime lender — had closed its doors and fired 800 employees. It made more than $8 billion in mortgages in 2005, but essentially shut down overnight when it ran out of cash because of the fallout from a surge in bad loans.

Since then, things have gotten much, much worse in the mortgage business: Roughly 100 lenders of all sizes have either sharply curtailed their operations, exited subprime lending entirely, or gone bankrupt.

Meanwhile, all the careless investors who snapped up heaps of high-risk mortgage bonds have suffered billions of dollars in losses as the value of those bonds and related derivatives have plunged.

Initially, the mainstream line on Wall Street was that the debt market problems would remain contained to subprime mortgages. But I disagreed …

I said that too much easy money was fueling parallel bubbles outside of housing, including in one distinct market — private equity .

I chronicled how bankers were talking about $100-billion takeover deals just like they used to toss out $1,000 price targets for Qualcomm shares during the dot-com bubble.

I pointed out that brokerage firms were layering on risk like crazy, by advising, financing, and investing in takeover deals.

Most importantly, I said that a lot of these buyouts didn't seem to be cases of private equity companies fulfilling their traditional role — taking over troubled companies, cutting the fat, fixing them up, and turning out new lean and mean corporations. Rather, many deals were being launched simply because firms had too much money being thrown at them.

Sure enough, things are starting to come unglued. Nervousness about the subprime industry is now spilling over into corporate lending. Investors are no longer willing to buy the super-risky bonds and leveraged loans that fueled the private equity takeover mania.

Two prominent examples:

• Buyout firm Kohlberg Kravis Roberts & Co. has been struggling to raise $18.5 billion to take over Alliance Boots in Europe. It looks like several of its bankers are going to get stuck holding the bag on $10 billion of loans. They also had to raise rates and cut fees on another batch of loans to get them moved.
• The sale of car maker Chrysler to another buyout firm, Cerberus Capital Management LP, is also going poorly. Banks are going to get stuck with another $10 billion of loans because investors refused to step up to the plate.

This quote from a Bloomberg story says it all:

"'People have basically put the Closed for Business sign out,' said Shelly Lombard, an analyst at bond-research firm Gimme Credit Publications Inc. in Montclair, New Jersey. 'You never know what's going to make it switch, but investors turn that switch off so fast.'"

All told, Bloomberg figures that at least 35 bond and loan deals have been yanked, pushed back, or restructured in just the past month and a half.

And the credit contagion doesn't stop there, either. Just look at the rapid deterioration in the market for Collateralized Debt Obligations, or CDOs. Those are the securities we've been talking about that hold slices of various other corporate, mortgage, and consumer loans and bonds. JPMorgan Chase says just $9.1 billion worth of CDOs were sold in the U.S. this month, a huge decline from $42 billion in June.

Luckily, you were prepared. A month ago, Martin told you all about the unfolding debacle in CDOs and what the implications would be.

What's Coming Next in this Unfolding Financial Crisis?

Look, I wish I could say this is no big deal. I wish lenders, policymakers, regulators, and investors had acted prudently for a change, and taken the proper steps to avoid a mess like this in the first place.

But they didn't. They fell for the lure of easy money hook, line, and sinker. Now, a wave of financial reality is washing over them like a hurricane-driven storm surge.

My advice: Get the heck out of the way!

Avoid housing and mortgage stocks like the plague. Dump shares of vulnerable banks and brokers. Stay focused on foreign markets and economies that aren't exposed to the whirlwind of problems facing the U.S. real estate market. Keep your fixed-income money in safer investments, like short-term Treasuries, rather than junk bonds.

Even consider taking some profits, like we just told our Safe Money Report subscribers to do. By our reckoning, they should have bagged 32.3% in just under three months on a position in a Brazilian power company and 19.3% in five months on a high-yielding New Zealand telecommunications provider.

Speaking of Safe Money readers, they've been prepared for this for many weeks now. They own three rounds of inverse exchange-traded funds — ETFs that go UP in value when the market goes down. One has surged 32% just since it was first recommended in early June.

Bottom line: We're in an extremely volatile period, with multiple credit markets showing signs of seizing up. This will eventually pass, and there will come a time when it'll make sense to scoop up some real estate bargains and snag a high-yielding bank stock or two. But smart investors know that sometimes the water's just too rough to wade in.

Until next time,

by Mike Larson

P.S. If you'd like to learn more about hedging yourself from the real estate and financial sector meltdown, subscribe to Safe Money Report .

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