Agora Financial’s Rude Awakening

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• Empty promises and vague confessions – yep, sounds like the banking
  industry,
• Pulling apart the numbers in the subprime mess – what’s still to come,
• And, the Options Hotline Half-Price Countdown ends TODAY! More below…

Joel Bowman, with a few words from Dubai…

They say the best lies are laced with a little truth. We guess it throws
credulous naivety off the scent of the real story.

Given that we here at the Rude Awakening are generally skeptical of anyone in
a suit (we prefer to wear shorts and flip-flops ourselves), we were a little
wary of the Big Bank’s confessions when the first wave of the subprime mess
hit their fans.

“Okay…we’ve written off $XXX, in dodgy loans. Now do you trust us?” they
pleaded. For us, this just didn’t seem to wash.

It didn’t sit right with Adrian Ash, either. Adrian is our London
correspondent and a regular contributor to the Daily Reckoning, MoneyWeek and
other fine publications. In the column below, Mr. Ash takes a look at a
basket of empty confessions and investigates the real subprime deluge yet to
come. Enjoy…

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Sub-Prime? So Over! Part I
By Adrian Ash

Phew! That was close! For a moment there, it looked like the collapse of the
subprime mortgage market was going to erase billions of dollars of financial
earnings for years to come.

Bad mortgage debts were piling up faster than trash bags in a landfill. At
least, that’s how the credit markets saw the subprime meltdown in August. Two
subprime hedge funds at Bear Stearns had gone bust in June; Ben Bernanke,
head of the Federal Reserve, said in July that total subprime losses could
total $100 billion; private-sector economists put the total nearer to $150
billion. Now MacroMavens in New York thinks we’re looking at $210 billion to
$346 billion – “and that’s assuming the situation doesn’t get worse.”

These billions in bad debt would seep into the broader economy, investors
feared, and kill the market in new lending dead.

But hey, panic over!

“They revealed all of it,” as a friend of mine – now senior analyst at a
leading mutual fund here in London – told me over a beer (or three) late last
week at the John Snow pub on Broadwick Street.

“Trust me,” my friend continued, “I’ve been through the disclosures. I was
there for Deutsche Bank’s results last week. They’re writing down more than
$3 billion…all the banks are clearly stating their subprime losses, too.

“Sorry Adrian, but there’s nothing left to hide. Nothing to see here…”

This happy view of “Subprime? So over!” is certainly what the banks
announcing their Q3 numbers this month would like the world to believe. And
the write-downs sure look dramatic enough to mark the end of the crisis in
subprime bad debt:

• Citigroup, the biggest bank in the US, reported a 57% drop in third-
  quarter earnings from a year earlier, due in no small part to bad mortgages;
• Bank of America, the second-largest US bank, just reported a 32% drop
  in earnings, led by a loss of $527 million in revenues at its structured
  products division;
• J.P.Morgan, the third biggest bank in the US, has marked down $186
  million in bad mortgages plus $339 million in debt-derivatives for June-
  Sept.;
• National City Corp. of Cleveland – the ninth-largest bank in the US
  according to Reuters – now projects mortgage-book losses of $160 million for
  Q3, “the high end of its previous forecast”;
• The leading US savings and loan, Washington Mutual (WaMu), says it
  expects a 75% drop in profits, with a new set-aside of almost $1 billion to
  cover bad debts and a hit of $410 million to its current lending portfolio;
• Sovereign, the No.2 savings and loan firm, has raised its bad-debt
  provision three times over to $155 million, adding another $35 million in
  mortgage-loan charges and writedowns;
• Some 170 investment bankers are losing their jobs at Credit Suisse
  after it warned of a 29% drop in operating profits;
• Nomura, Japan’s largest brokerage firm, says it expects to lose $621
  million by shutting its US mortgage division after heavy losses taken over
  the summer;
• Merrill Lynch wrote down $5.5 billion in subprime and leveraged-loan
  losses for June to Sept., with around $4.5bn lost to bad home-loans alone.

After this round of third-quarter mea culpas, most investors seemed eager to
forgive and forget. Banking stocks have risen by nearly 13% from the bottom
hit in August. And professional analysts like my friend at the John Snow pub
are happy to take the banking world at its word.

“Deutsche Bank joins a conga line of banks coming clean,” says FinancialWeek.
“Swiss bank exposes holes in Q3 results,” adds a French newswire, reporting
that UBS, the world’s biggest wealth manager, expects to lose $3.4 billion on
its subprime mortgage book.

“Coming clean…exposing holes…” This is the language of honest men
‘fessing up and moving on. “While we’re disappointed with our anticipated
third-quarter results, we look forward to an improved fourth quarter,” says
Kerry Killinger, chief of Wamu.

“While it is very early in the current quarter and despite continued
challenges in structured finance, we are beginning to see signs of a return
to more normal activity levels in a number of markets,” says Stan O’Neal,
head of Merrill Lynch.

In short, “we see substantial opportunities in investment banking after this
period of correction,” as Josef Ackermann, head of Deutsche Bank, put it.

If we are to believe all these optimistic press releases, the worst of the
credit crisis has passed. Yes, subprime was a mess, the world’s highest-
ranking bankers admit, but it’s been cleared up and tidied away like the
trash of beer cans and tequila bottles after a 21st birthday party.

But what if the optimistic bankers and press releases are wrong? What if the
crisis is still far from over?

Back in the US housing market – the source, remember, of all those defaults
and delinquencies now hitting investment-bank profits – the trouble looks to
have barely begun:

• Construction of new homes plunged to its lowest level in 14 years last
  month, down more than 10% from August according to the Commerce Dept.,
  swamping consensus forecasts of a 4.2% decline;
• US home foreclosures rose by 93% in the year to July said John Dugan,
  US Comptroller of the Currency, in recent testimony;
• Fitch – the ratings agency – has caught up with the junk it previously
  stamped as investment-grade, hiking its default forecast for one set of bonds
  by 50% this summer;
• Four months after issue, 6.3% of the home-loans bundled into mortgage-
  backed bonds during the first half of 2007 were 60 days late with repayments
  or more. “The rate was 4.2% after four months for bonds created last year,”
  says research from Moody’s;
• More than $250 billion worth of US mortgages will reset to sharply
  higher interest rates in 2008 and 2009, and “another $700 billion will do so
  in 2010 and beyond,” says a study from First American.

“I foresee several million [foreclosures],” warns Bill Wheaton of MIT’s
Center for Real Estate studies. “I think that we could easily see 2 to 3
million people lose their homes and go back to renting, basically.”

But would that scale of wipe-out on Main Street matter to Wall Street?

Well, if the investment banks were now home and dry, why would Citigroup,
J.P.Morgan and Bank of America have agreed to back an $80 billion “off-
balance sheet” fund that will actively seek to support the value of US home-
loan securities?

If the whole problem has been dealt with in one quarter, why would US
Treasury Secretary Hank Paulson – a former chief of Goldman Sachs, no less! –
want to bang heads on Wall Street and get this deal set up?

And if the trouble in subprime were over, why didn’t Goldman Sachs step up to
join Paulson’s bail-out baby?

“[The banks] may firmly believe this gets everything out of the way,” says
one analyst of the mass confession given in Manhattan, Frankfurt and London
this month. “But I think there’s going to be further reserve additions in
future quarters.”

“I’m pretty bearish on the whole banking sector,” he adds. In our humble
opinion, that sounds a fair call.

All told, the ongoing subprime crisis is just one more reason why we’re
sticking with gold, rather than paper promises.

Because there’s more trouble to come in paper. Much more.

[Joel's Note: City correspondent for The Daily Reckoning in London and a
regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold
News and head of research at BullionVault – where you can buy gold today
vaulted in Zurich on $3 spreads and 0.8% dealing fees.

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——————————————————–

Rude Endnote: Got a comment or question for your Rude team? Send all subprime
related emails to the address below.

In the meantime, keep a look out for your 5-Minute Forecast. Addison and Ian
are loading it up and will fire it your way shortly after lunch.

Cheers,

Joel Bowman
Rude Awakening

P.S. Remember, you’ve only got until midnight to grab a spot on our most
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