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Subprime Storm Mimics Katrina

Monday, July 30, 2007

Wall Street may have reason to worry about a financial hurricane poised to do the same kind of damage Hurricane Katrina did — in terms of money and assets lost — in New Orleans in 2005. Given the latest storm warnings about subprime mortgages and the Dow’s dive last week, it looks like "Subprime Katrina" might become the financial storm of the decade.

Wall Street investment bankers who remember the devastation in New Orleans might want to start battening down the hatches. In fact, some of them seem to understand their pending doom as they try to cajole the rest of the world into thinking that the subprime (otherwise known as low-quality) mortgage contagion is contained. "Sure, sure, Bear Stearns got hit when its subprime hedge funds lost their value, but everyone else is O.K.," they say. "Let's all heave one collective sigh of relief that we dodged that bullet."

Does that attitude sound familiar? It's exactly how the people of New Orleans felt for the 8-10 hours after Hurricane Katrina whipped up the Gulf Coast and dumped its rain. It was over; they had dodged the bullet. Their beautiful city that is built below sea level and surrounded by sea walls and levees was safe.

That's where Wall Street is right now – hoping the levees will hold as investment bankers try to sandbag the rest of us with lots of placating talk. Well, it turns out that New Orleans was about as safe as the subprime bonds that are now below their own "C" level.

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Although Wall Street bankers have been doing one heckuva job, I think it's too soon to breathe easy, just as it was too soon then for those in the Big Easy to breathe easy. Because right now, we're in that eerie quiet period when everyone thinks that the subprime storm has blown over and headed east. We're all oblivious to the larger problems coming behind it. Just like when New Orleanians breathed their collective sigh of relief, oblivious to what a few city engineers worried about and watched for: Would the levees hold, or would they be breached?

We shouldn't give into that false sense of relief, and here's why: Wall Street was warned about the coming hurricane-force fall-out from subprime mortgages, and it ignored the warnings, buying up all the securities backed by subprime mortgages that it could. Subprime Katrina actually did hit hard and wiped out one of Bear Stearns' hedge funds invested in subprimes valued at $6 billion. It left the other hedge fund at only 10% of its original value.

But now that this episode is behind us, Wall Street is having trouble selling more debt. News came this week that the group of Wall Street banks that is raising funds for GM had to postpone a $12 billion debt offering, because investors wanted better terms. It sounds like it may be too late for many Wall Street denizens to get out of town – and their positions – before the floodwaters start rising.

Nor is everyone buying the argument that now we're safe. The Economist magazine (June 21, 2007, issue) suggests that "perhaps the most worrying thing for financial institutions holding mortgage-backed paper is not the subprime market itself, but the unnerving parallels with an even bigger one to which they are also exposed: leveraged loans to companies." The story also quotes Daniel Arbess of Xerion Capital Partners as saying that subprime might well be “a dress rehearsal for something bigger and scarier.”

Doug Casey, who writes The International Speculator newsletter, agrees in his July 2007 issue. Referring to the $6 billion hedge fund wipeout, he writes, "There could be hundreds of billions more in losses. And it's impossible to say which firms that are bankrupted by the default may in turn default on debts to others, like a string of dominoes."

Remember, too, the finger-pointing and blaming that started as soon as the rest of the nation realized that the U.S. government was not doing enough to help New Orleans? The editors of The Elliott Wave Financial Forecast recognize a similar change in attitudes toward Wall Street:

"The unwinding process will be sped along by a flood of revelations about illicit hedge fund and investment banking activities. Just as Enron, Tyco and a host of other primary beneficiaries of the late 1990s bull market run became the focus of scandals, hedge funds and the banks that enabled them are starting to become a focal point for scrutiny." (The Elliott Wave Financial Forecast, July 2007)

Then will come the final installment. Just as the U.S. government was slow to come to grips with the disaster in New Orleans so that people were left to fend for themselves, so too will investment bankers and investors have to fend for themselves. They may find themselves clutching their worthless paper and wishing someone would bail them out from the rooftops of their now-worthless homes.

And if this analogy holds true, Heckuva Job Brownie – now known as Helicopter Ben Bernanke and his Federal Reserve team – won't have any more luck picking up the pieces on Wall Street than FEMA did in New Orleans. Neither the federal government nor the Federal Reserve did the heavy lifting up front to avert these natural and financial disasters.

So telling us now that the subprime problem is contained sounds too much like wishful thinking, the kind that the federal government indulged in as the floodwaters started rising in New Orleans two summers ago.

Susan C. Walker writes for Elliott Wave International, a market forecasting and technical analysis company. She has been an associate editor with Inc. magazine, a newspaper writer and editor, an investor relations executive and a speechwriter for the Federal Reserve Bank of Atlanta. She is a graduate of Stanford University.

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