Saturday, March 8, 2008

How Housing has put the whole economy at risk

I will post a video below of Art Cashin who I believe is one of the smartest guys on the street. He has 30 plus years in the market and is the head of trading for UBS.

If you have watched CNBC over the last 5 years they love to call this economy the "goldilocks" economy, meaning everything is fine and dandy and people like Larry Kudlow have repeatedly said that the housing problem is "contained" and has not spread into other parts of the economy.

Well it is becoming increasingly obvious to Art Cashin that "goldilocks" has had a "heart attack" and needs a "parachute" and needs to go to "rehab" in order to be saved.

Another comment that's becoming increasingly popular with Art and others on the street is "we don't know what we don't know". I find this to be extremely important. The subprime problem has spread into everything. This is called contagion. Contagion is the thesis that one problem like suprime can spread into many parts of the economy and wreak havoc in areas you never thought would have problems.

Many people are thinking where should I safely invest in the economy as the housing market implodes? Well because of contagion some areas of the economy that people have always considered to be safe are now potential time bombs. My biggest area of concern here is the money markets. This is where many people go when the economy gets bad in order to protect themselves. Well subprime has no longer made money markets safe. Why? Because many of them bought CDO's!!

AAA rated CDO's were offering 10% returns. As a result many money market funds got greedy and bought many CDO's with that 10% return they would then payout the average MM return of around 5% thus making a 5% spread or profit on the difference.

So when these CDO's started blowing up due to foreclosures many were marked in value to zero. So now some money markets owe more to their customers then they can payout because they have been forced to write off many of the CDO's that they used to make a 5% profit spread on.

The contagion part of this thesis is CDO's were also bought by pension funds, college endowment funds, and banks based on their lucrative return because they were AAA rated by S&P and Moody's. This is turned out to be a joke because Wall St. was paying these agencies to give these bonds a AAA rating. This is where the biggest fraud is IMO. It may go down as one of the biggest frauds in history. How can a rating agency rate credit independantly when their customers are the Wall St. banks? These agencies obviously felt pressure to rate bonds AAA because Wall St. was paying them to do so. This is a total conflict of interest. One of the changes I expect going forward is these rating agencies will be paid in different ways for rating debt either through the buyers of credit or an independent agency.

So folks "we don't know what we don't know" meaning until all of these pension funds, banks,endowment funds admit how involved they got into CDO's or any other AAA rated debt that really isn't true AAA debt. FYI, AAA debt is supposed to never go bad. EVER. Well the crooked rating agencies destroyed this trust because they were being paid by the people who were structuring this debt and a lot of it should NEVER have been rated AAA rated because most of it is laced with small pieces of subprime mortgages which are garbage.

Until we know what we need to know and these institutions come clean I would avoid the stock market. "goldilocks has had a heart attack and needs a parachute" according to Art Cashin. If you watch CNBC/CNBS, pay attention to this guy. He can save you a lot of money and tells you whats really going on versus these "permabulls" who tell you day after day that "Now is the time to buy!!"

Art also comments on the psychologic aspect of this market which I think is extremely important. FEAR is dominating Wall St. and until these financial institutions come clean, WE DON"T KNOW WHAT WE DON'T KNOW. As a result I would buy fixed income investments like CD's, treasuries, and safe Money market funds like Vanguard who are very conservative and stayed away from CDO's and ride out this storm.

Cash will be king after this mess subsides and houses will dirt cheap and easy to buy if you have cash. The smart guys on the street are talking about "capital preservation" versus trying to make big returns in the stock market in 2008. Why do you think short term treasuries are returning only 1.5% instead of the normal 3-4%. This tells you what the smart money is doing. They are flying to cash in treasuries instead of buying stocks thus knocking down the returns down to 1.5% and riding this storm out.

So my advice is to preserve capital in a lot of fixed income and have money to invest when you feel this market is finding a bottom. IMO the bottom is still very far awy. We are only half of the way there because during the average recession stocks drop 28%. We have only corrected about 15% so far.

If you platy defense whats your worst case scenario with this playbook? you make 3% returns versus the average 8-10% return during the bull market. With all hell breaking loose in the markets I am more then willing to give up an extra 5% in returns when I think the downside risk is 30%. If stofcks turn and I miss the first leg up its ok. I will have saved 30% on the downside. This just gives me more money to invest when things turn around because I preserved capital.

My bottom line is similiar to Art's. Until we know what we need to know its stupid to buy into this market. We will know soon what all of these financials did and what their exposure is and when we do know the losses it will be time to throw some money back into selective names that are good companies.

This capital preservation will allow you to put a nice down payment on your cheap house after the bubble pops. The time bomb is about to explode and make sure you protect your assets so that you are ready to take advantage of buying a house at bargain basement prices.

Here is Art:

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