FSO Editorials: "The Devil's Triangle" by Dr. Joe Duarte 03/03/2007

THE DEVIL'S TRIANGLE
China, Private Equity, and the U.S. Real Estate Bubble
by Joe Duarte, MD
Joe-Duarte.com & IntelligentForecasts.com
March 3, 2007

Editor’s note: Wall Street got rocked this week as global markets fell out of bed, and the volatility has continued. Yet, as the 30 second, 100-point swings in the Dow Jones Industrials attest to, few have a handle on what happened, and what it may mean. The truth is that the current situation, although precarious, is unpredictable, and as in previous volatile periods, may amount to little more than a blip, as central banks cut interest rates and paper over the losses. Yet, by no means is this situation not to be taken seriously. It is also not a one-dimensional picture. It is a complex and complicated scenario and has been in the works for some time with Dr. Duarte being one of the first analysts, in April 2005, to put together a clear and concise scenario with regard to the high risk in China, and its possible outcome. The article can be found here.

Although Dr. Duarte has been warning about the risks of China to the Financial markets for some time, (see links below), over the last few weeks, his focus had returned to China, while the rest of the market remained extremely complacent. Finally, it is important to make the connection between the Chinese economy, its stock market, and the U.S. economy, the U.S. housing sector, and the recent real estate bubble, as well as the private equity phenomenon. These are the pillars of the latest economic expansion. And these are the areas, which have spawned the latest set of trouble for the global financial markets. Dr. Duarte is not calling for the end of the world, or a global economic crash, although it is one of many possible outcomes to the current situation. Yet, it is important for all investors to understand what is happening, and how it may affect their own investments. In this series, presented chronologically, Dr. Duarte puts a great deal together for the reader to review and consider.

Other important background articles can be found at the following links:

02/12/2007 REITs: A New Dawn?
07/02/2006 The China Syndrome, Part 9
06/24/2006 ARM Implosion Straight Ahead

Housing: Loan Troubles Ahead
Key Housing Data Ahead (January 25, 2007)

Housing loan delinquencies are near their all time highs, an economist told the Wall Street Journal. According to the paper: '"the total mortgage delinquency rate is the highest that it's been since the depths of the [2001] recession," says Mark Zandi, chief economist at Moody's Economy.com. He attributes the increase in part to the weaker housing market and the widespread use of adjustable-rate mortgages, many of which now are resetting at higher rates.'

Although the big picture is now all about Iraq and its effect on the upcoming presidential election, the U.S. stock market still has to deal with economic data and the potential effect of the numbers on the Federal Reserve's actions at the end of the month.

The thought of a rate cut has almost been erased. Yet, there is always the potential for the central bank to raise rates, although that has diminished over the last few weeks.

One of the major reasons for a slowing economy, oil prices, has eased, although that could change, as oil seems to have made some kind of bottom in the last few days.

That leaves Wall Street to fret about housing, at least for today, when December existing home sales will be released around 10:00 Eastern time.

Expectations are for a decrease in sales of some 0.5%, according to the Wall Street Journal, and there might be a surprise to the down side, if the number of defaulted or in trouble mortgages rises far enough.

According to the Journal, the number of delinquent or in trouble mortgages is on the rise, prompting banks to move faster to avoid foreclosures. The problem, as we have noted here several times, is the fact that adjustable rate mortgages are running out and new loans have higher interest rates. That means that monthly payments are on the rise, and homeowners who bought beyond their means are not able to make payments.

The Journal added: "The increase in bad loans is broad based, with delinquencies rising in the past year in roughly 80% of the 250 local areas analyzed by Moody's Economy.com. Some of the biggest increases have come in California, where high prices have made it hard to afford a home, and in other once-hot markets such as Las Vegas and Port St. Lucie, Fla. Among the handful of major metropolitan areas where delinquencies have fallen: Salt Lake City, San Antonio and Albuquerque, N.M."

Moody's Zandi, told the Journal that things could get worse: "What is more, as demand for loans softened, mortgage lenders loosened their standards and made riskier loans, Mr. Zandi says. He expects that nationwide delinquency rates could rise by as much as a full percentage point from current levels in the next year, but he doesn't expect the trend will have a significant impact on the overall economy."

Conclusion

The homebuilders have been telling Wall Street that the worst might be over for their side of the business, new housing. But, that does not mean that existing homes aren't going to see a harder road ahead.

If today's data shows a bigger decline than expected on existing home sales, the stock market, almost certainly the housing sector, could take notice.

The bond market, where interest rates have been creeping up of late, might also take notice.

An upward suprise in existing home sales, possibly linked to warmer than usual December weather, might make for an interesting day in the market.

This would be a good day for those in the housing sector to keep a close eye on their stocks.

China Stumbles
Speculative Bubble Building (February 6, 2007)

The Chinese stock market is in the midst of a long forecast correction, but the jury is still out on whether this is a pause that refreshes or the end of the multi-year bull market.

The Chinese government has been increasingly concerned lately about the rise in speculation within the general population, where classic signs of a major top, such as mortgaging homes to using credit cards to invest in the stock market have been increasing, according to some reports.

U.s. traded exchange traded funds that specialize in China are off as much as 10-12% since late December, with the ishares Trust FTSE Xinhua Index ETF (AMEX: FXI) providing the old "picture is worth 100 words" illustration.

Chart Courtesy of StockCharts.com

According to the Wall Street Journal: "In a frenzy that recalls the late-1990s dot-com boom in the U.S., the rally has drawn in a new generation of investors. Online trading is spreading rapidly, and in recent weeks individuals have been opening stock-trading accounts at the rate of about 90,000 per day, 35 times the pace of a year earlier."

In fact, the Journal describes scenes more reminiscent of the roaring 20's in the U.S. prior to the crash of 1929 and the Great Depression: 'At an outlet of Tian Tong Securities in Beijing, Li Hua, a 41-year-old housewife, said she opened her first trading account yesterday after watching stocks soar over the past year. "I want to try my luck," says Ms. Li.'

More than anything, the government is now fearful of a major market crash before the 2008 Olympics; "Regulators say they are increasingly seeing signs that investors, caught up in the stock mania, are pledging their homes as collateral for personal loans, or teaming up with merchants to, in effect, borrow from their credit cards, presumably hoping that stocks will rise enough before the bill comes due to pay off the debt."

The situation, especially with credit cards is serious enough for the Chinese government to have warned banks about "suspicious" credit card transactions. The scheme is akin to a strange margin transaction: "The credit-card maneuver typically involves a merchant who agrees -- in return for a commission -- to process a transaction that allows the cardholder to get cash at a lower cost than a conventional cash advance." The card holder then takes the low interest loan and invests in the stock market. But "Investing borrowed money is risky, however, because if the market reverses course, investors not only lose on their stocks, they are also on the hook to repay their borrowings."

The government is so concerned, that aside from prohibiting the sale of new mutual funds so far this year, it broadcast a television program warning investors about the risk that can be found in the stock market. According to the Journal: 'state-run China Central Television broadcast a midday program citing the risks of stock-market investing, in particular the "taboo" practice of funding stock purchases using homes as collateral. "Even in a bull market, 30% to 40% of people would suffer losses," the program's anchor said. The broadcast "was arranged according to a requirement of the Central Propaganda Department," says a person with knowledge of the situation.'

Part of the reason for the concern, aside from the fact that the Olympics are coming up, and that China is projecting its financial, political, and military presence abroad is the fact that history clearly points out what can happen in the Chinese stock market, and its consequences to the government. "China's leadership is keenly sensitive to the political risk of a slumping market. In the previous bull-bear cycle, stocks fell for almost four years straight after the Shanghai Composite peaked in 2001, then tumbled sharply. At the start of that slump, some investors blamed the Communist Party for their losses, because the party's mouthpiece People's Daily had essentially endorsed stock investment just weeks before."

Yet, the history of the Chinese stock market is rocky, to say the least as "In the first three years after stock trading began in China in 1990, the Shanghai index jumped by a factor of six, a rally so intense that riots broke out among people hoping to get in on initial public offerings. Throughout the 1990s, stock manipulation and other scandals became commonplace, exacerbating huge swings in stock prices. Then, in 2001, investors grew unnerved by the high price of stocks, as well as the government's high levels of corporate ownership, and the market's foundations crumbled."

Meanwhile, the corruption crackdown in Shanghai is continuing, with the final outcome still pending.

Shanghai has been the bellwether for the Chinese miracle, with its futuristic high rise buildings and pro-West economic boom serving as vanguard. Yet, according to the Wall Street Journal: "underneath the boom and glitter, Communist Party leaders in Beijing say, lay a secret: massive corruption."

Indeed, with the city leader Chen Lyangyu detained at an "undisclosed" location, the future of the city and its massive projects are in doubt. Among them is the continuation of the ATP Masters Cup final tennis tournament, which was held this past December in an arena built by Mr. Chen, a big tennis fan.

The Journal describes the business model of Shanghai Inc., as the city's miraculous boom was known, as one in which lines of funding were blurred and "Giant construction projects got funded from public coffers; choice assets moved out of state hands in elaborate transactions; and plum contracts went to the well-connected."

The upstroke of the current situation in Shanghai and the volatility in the Chinese market, seems to be that foreign investors are starting to take pause.

Conclusion

The situation in China should not be surprising to anyone with any experience in investing, or a realistic view of how societies and politicians operate.

The world is moved by two major factors, money, and the power to wield it. In China, Shanghai had both, until the early 21st Century when power shifted at the top of the Chinese government.

And in China, it's still all about the government, regardless of what the propaganda and the hype say.

From a market standpoint, though, a meltdown in China, when it comes, will have significant repercussions around the world.

The big question is not if, but when.

REITs: A New Dawn?
Private Equity's Big Day In Commercial Real Estate (February 8, 2007)

The MSCI U.S. Real Estate Index (RMZ) shot up to an impressive new high on 2-7, as the Blackstone group won a long and difficult bidding war for the Equity Properties Trust. Yet, the charts and the deal itself suggest that the pace of commercial real estate is unsustainable.

Chart Courtesy of StockCharts.com

To be sure, calling a top in any kind of brisk market such as the real estate investment trusts have been for the past several years, is difficult. But, when oil was at $80 per barrel last summer, the calls for $200 oil were the norm. And as the recent action in oil shows, $60 is now a tough ceiling for crude.

Every major secular bull market, eventually meets its maker. And one of the sure signs that something might be about to change is when a big deal gets lots of press, and either falls through, or is interpreted by the market and the media as the deal that will take the market to yet a new and more amazing paradigm.

The Blacktone/Equity Properties Trust deal fits the latter category, as the Wall Street Journal noted: "Blackstone Group's $23 billion buyout of the owner of the biggest portfolio of U.S. office buildings will send ripples through the real-estate world, with a good chance it will raise the ceiling on already-record prices."

The Journal added: "With office buildings in red-hot demand as investment vehicles, Blackstone's control of prime properties likely will put it in position to demand prices on its individual buildings high enough to make the private-equity firm's bid pay off. The deal, approved yesterday by Equity Office Properties Trust after rival bidder Vornado Realty Trust bowed out following weeks of bidding, also cements Blackstone's clout as one of the most powerful investors on Wall Street."

But in the same article, the Journal noted that part of Blackstone's strategy to make the deal pay off is to sell choice properties in Equity's choice portfolio of Manhattan buildings, the crown jewels of the portfolios, as they deliver record level rents.

Blackstone says that one of the reasons it continued to outbid its rival, Vornado, was that there were so many buyers ready to take the big buildings off of their hand once the deal got done.

In fact, what Blackstone is hoping to do, is to sell the Manhattan buildings to hot money as "Blackstone already has agreed to sell -- or is close to lining up buyers for -- a substantial piece of Equity Office's holdings, including much of its prime Manhattan portfolio. Demand for such buildings has been frenzied. Sales of U.S. office buildings rose 32% in 2006, with relatively modest new construction. The investors include foreign oil magnates seeking a haven to park cash, pension funds looking for reliable returns and private-equity firms wanting a percentage of their portfolio in real estate. If Blackstone scares off some potential customers by demanding higher prices, it is confident others will queue up to take their place."

To us, this sounds like the latest round of the greater fool theory, much as when the Japanese bought Rockefeller Center in the late 1980s, just as the Japanese economy was about to implode, and the U.S. savings and loan debacle was about to hit its stride.

In fact, there is plenty of bravado being thrown about on Wall Street these days, as "Market observers say Blackstone's win is a vivid illustration of how private-equity firms now have a leg up in the battle for control of companies and assets such as commercial real estate in the U.S. and elsewhere. Among the reasons: the closely held investment firms are more comfortable putting loads of debt on their targets than publicly traded buyers at a time when the debt market is willing to provide massive amounts of money at record low prices. In addition, private-equity firms can move more quickly, with no need for messy shareholder votes."

In other words, private equity is willing to take huge risks that a publicly traded company would not normally take, aside from Enron and Worldcom types along with others destined for the trash bin.

The problem with that scenario is that at some point, debt has to be serviced. And when it is so large that creditors start to balk, life can become very difficult for the groups that took on the leverage in the first place.

A perfect example of deals going bad is the warning by banking giant HSBC about its upcoming earnings. The company is taking a $1.76 billion charge due to mortgage payment defaults.

Talk about buying the top. According to Marketwatch.com: "The problem is with the bank's portfolio of sub-prime mortgages, which it snapped up in 2005 and 2006, before the U.S. housing slowdown began to bite."

Somehow, HSBC, the world's third largest bank, in 2005 and 2006 couldn't figure out that the U.S. housing boom would eventually end, and Wall Street analysts are shocked.

According to Marketwatch: '"This a material negative surprise for HSBC. Moreover, the timing of this news is also surprising as this is the first time in our memory that the bank has pre-announced material information so close to a formal results announcement," said John-Paul Crutchley, an analyst at Merrill Lynch. '

Conclusion

To us, it looks as if the Blackstone Group is likely to get away with its strategy. Obviously, somebody pawned off a sizeable portfolio of bad loans onto HSBC. And if indeed there are already buyers lining up to take the big buildings off of Blackstone's hands, then congratulations to all concerned.

But then, if you just spent months fighting to own those highly coveted assets in Manhattan, why would you be selling them even before the deal closes?

Could it be that the Blacktone Group knows that the commercial real estate market is about to take a powder and it's getting out of the highest risk properties as quickly as it can before the market crashes?

If we were big rich guys from the oil patch, we'd be buying natural gas deposits in Forth Worth right now, just like Exxon Mobil is, not ridiculously priced Manhattan real estate at the end of bull market.

But, what do we know? We're just sitting here looking at stuff on computer screens and trading for a living.

One thing's for sure. It wouldn't be the first time somebody on Wall Street sold some poor sucker a bill of goods

Payback: Big Money Gets Tough On Bad Mortgages
Chain Reaction (February 15, 2007)

Small mortgage lenders, often specializing in high risk and highly convoluted mortgages are facing the dark side of Wall Street as major investment banks and brokers are demanding their money back on defaulting loan packages.

One of the most traditional hedges in the real estate market, the reselling of mortgages, is delivering major blows to small firms, with bankruptcies in the sector rising. According to the Wall Street Journal: "As more Americans fall behind on mortgage payments, Merrill Lynch & Co., J.P. Morgan Chase & Co., HSBC Holdings PLC and others are trying to force mortgage originators to buy back the same high-risk, high-return loans that the big banks eagerly bought in 2005 and 2006."

According to the Journal: 'Merrill demanded in December that ResMae Mortgage Corp. -- which in 2006 sold it $3.5 billion in subprime mortgage loans, or loans to borrowers with poor credit records -- buy back $308 million of loans whose borrowers had defaulted. In a filing this week for bankruptcy law protection, ResMae said those demands "crippled" its operations. The Brea, Calif., company said that repurchase requests were "severe and unexpected."' And Resmae is not alone. According to the Journal: "Accredited Home Lenders Holding Co., a subprime mortgage lender based in San Diego, reported a loss of $37.8 million for the fourth quarter, partly due to heavy repurchases of dud loans from large loan buyers, compared with a year-earlier net income of $43.3 million."

In effect, what is happening is that the chain reaction has begun, as "as home-price appreciation fell and borrowers faced rising interest rates, more people defaulted on their mortgages. That prompted Merrill Lynch and others to exercise their contractual right to demand the sellers buy back the loans. Under mortgage contracts, mortgage originators must often repurchase loans that default very early in their term or that come with underwriting mistakes, such as flawed property appraisals."

Aside from exercising safety clauses in contracts, some investment banks are going further. The Journal reports that "HSBC, which last week added $1.76 billion to its bad-debt costs for 2006 to cover ailing mortgages, has sued several small lenders in federal court in Illinois after they refused HSBC's repurchase requests."

what makes this most interesting, is that it is a rare occurrence for investment banks and others in the mortgage reselling market to go after the seller. The Journal noted: '"Nobody was doing this in earnest before late last year," says Kevin Kanouff, president of Clayton Fixed Income Services, adding that he expects the volume of putbacks "to trail off in the third or fourth quarter. The carnage that you are seeing...is not over."'

Clayton Holdings is increasingly busy in the current situation and is "working with a half-dozen investment-banking firms to identify loans that should be repurchased. Clayton has also been hired by two hedge funds to review mortgage bonds they own for potential repurchases."

Conclusion

Fed Chief Ben Bernanke told Congress on Wednesday that the housing market is "stabilizing." And he may be correct, as far as home builders go. But, in our opinion, the news that HSBC is in the hole for nearly $2 billion in bad mortgages, and that Merrill Lynch, JP Morgan, and others are now starting to go after small independent mortgage brokers, is a sign that the next shoe to drop is a major problem in the mortgage market.

There are more problems ahead here, since this is a chain event, with several links. The Journal makes three points which are worth noting:

1. "As more subprime lenders face losses or bankruptcy, big banks also face another problem: Many lent money to small firms like ResMae so that those firms could make more mortgage loans to borrowers. It isn't clear how much of these loans will be paid back to the banks. Wall Street firms also are increasing their own internal generation of subprime loans by acquiring smaller mortgage loan originators or processing companies."

2. "In 2005 and 2006, banks such as HSBC and brokerage firms like Merrill Lynch went on a buying spree, snapping up subprime loans from typically small mortgage banks that had lent money to homebuyers. At the same time, many lenders were loosening their credit standards and making riskier loans."

3. "HSBC kept many of the loans, while Wall Street firms chopped the loans into pools sold to investors as mortgage-backed securities."

To us, it's that third line that stirs up the chill generator deep down in our spine, the fact that the risk was spread out into the mortgage-backed securities market. At some point, somebody is not going to get paid, and in turn won't be able to pay someone else. That's when margin calls start, and that's when those caught in the middle have to sell liquid things, such as blue chip stocks, in order to meet their margin calls.

Aside from the public bein involved, what worries us is the fact that hedge funds were involved, as the Journal reports. When hedge funds get involved, the risk to the market rises significantly, since those are the folks that sell first and ask questions later.

Greenspan: Rising Risks "Disturbing"
Few Listen To Alan Greenspan Anymore (February 26, 2007)
posted before the market opened

Former Federal Reserve Chairman Alan Greenspan thinks a recession is ahead and that investors are too complacent with regard to risk, says the Wall Street Journal. But, since he's no longer in charge of the interest rate "red button," few are paying attention to his remarks anymore. That may prove to be a risky proposition in the current marketplace.

Greenspan's remarks are more prophetic given the recent announcement of a $32 billion private equity financed takeover of TXU (NYSE: TXU) as reports are also surfacing about a possible $54 billion takeover of Dow Chemicals (NYSE: DOW).

Mr. Greenspan, almost as famous for his "irrational exuberance" comments as for his nearly twenty year stewardship at the Federal Reserve, was speaking to a satellite conference last week, and according to the Wall Street Journal 'responded to a question about the U.S. economy by saying it was "possible" that it would go into recession by the latter months of 2007, though he said it is difficult to predict the timing of any recession.'

Greenspan added: '"When you get this far away from a recession, invariably forces build up for the next recession, and indeed we are beginning to see that sign, for example in the U.S., profit margins ... have begun to stabilize, which is an early sign we are in the later stages of a cycle," he said. "While, yes, it is possible we can get a recession in the latter months of 2007, most forecasters are not making that judgment and indeed are projecting forward into 2008 ... with some slowdown."'

In what were wide ranging comments, the former Fed Chairman also noted that "the U.S. and global economies are far more resilient now than before due to economic and financial shocks, and said that rather than predict when the next shock would occur, policymakers should create an environment where economies are capable of absorbing unforeseen events."

And perhaps the most telling statement, reminiscent of his "irrational exuberance" comments, Greenspan told the audience: '"We have extraordinarily low risk premiums now. Risk is no longer perceived as major risk, at least as it was in years past and that, I must say, I find disturbing," he said. "We do not and cannot look into history without being very concerned when you see the absence of awareness and concern about risk that we see today."'

Greenspan's comments are interesting, not just because Greenspan said them, or because the market didn't crash after he made them, which is what might have happened if he uttered the same words while he was still at the Fed.

What makes them more interesting is the timing. First, the private equity mania continues, with larger and more aggressive deals getting done on an almost daily basis. Second, the Federal Reserve is looking at the economy in slightly different terms these days.

According to Greg Ip, the Wall Street Journal's well connected Federal Reserve reporter, the Fed doesn't think that there is a direct link between unemployment and inflation any more. More specifically, "The Fed's staff estimates it takes up to twice as much additional unemployment to achieve a percentage drop in inflation as it did before 1984."

Ip's conclusion is even more startling: "That's one reason the Fed, though it expects core inflation to ease this year, isn't relaxing. With unemployment currently 4.6%, at or below the Fed's view of its natural rate, inflation may edge up after the temporary impacts of energy and rent subside. That could require the Fed to raise interest rates enough to push unemployment up sharply and bring inflation down."

According to Ip's report, the Fed is looking at current inflationary pressures as being temporary, with rising rent and oil prices not quite being permanently factored into the inflationary equation by the public, whose expectations for inflation are still tempered. 'Fed Chairman Ben Bernanke echoed that sentiment earlier this month, saying the public's expectations will determine whether temporary factors like changes in rents and oil prices "leave a lasting imprint" on inflation: "It is encouraging that inflation expectations appear to have remained contained," he said.'

In other words, the Fed now thinks that if inlfation persists, it would take a more aggressive round of interest rate cuts than in the past to wring out the excesses of inflation, if they are not temporary.

Conclusion

Greenspan thinks that a recession is within the realm of possibilities. The Federal Reserve is thinking that the relationship between inflation and unemployment is no longer a reliable indicator of when to stop raising interest rates.

And private equity investors are apparently insatiable in their appetite, and why not, with the entire Wilshire 5000 index as a potential field of acquisitions in the future.

The weak link in the chain is that the whole scenario is based on liquidity. The Fed has sapped a significant amount of liquidity from the system with its previous interest rate increases. But, there is clearly a whole lot of money still sloshing around the system, as petrodollars are being recycled, and the fruits of recent megadeals are finding new homes.

Goldman Sachs continues to form private equity partnerships, and lenders are apparently not having any trouble loaning money to big funds for bigger and bigger deals.

But, we return to the key statements from above. Greenspan is looking at economic weakness in the future, and the Fed is looking at being more aggressive in its next round of interest rate increases.

The two viewpoints are incompatible, as is the viewpoint that the current private equity boom can last forever.

The Fed is feeling pretty confident these days. After all it busted the housing bubble and only the fringe players in the sub-prime mortgage sector ahve taken a hit.

What's to stop the central bank from thinking that it can be just as lucky with the commercial real estate market and the private equity bubble?

Report: Sub Prime Mortgage Risks Spreading
More Trouble Ahead (March 1, 2007)

Despite assurances from Fed Chief Ben Bernanke and others, the risk of rising defaults in the mortgage sector is spreading beyond the sub prime sector into the middle of the curve, says the Wall Street Journal.

Citing data from UBS AG, the Journal reports that the next sector with the potential to cause big problems is the Alt-A market, or the middle tier in the mortgage sector. These are still mortgages with a twist, but are offered to buyers with a better credit rating than the subprime sector, thus are expected to have a better chance of actually being paid.

According to the Journal: 'Data from UBS AG show that the default rate for Alt-A mortgages has doubled in the past 14 months. "The credit deterioration has been almost parallel to what's been happening in the subprime market," says UBS mortgage analyst David Liu. The UBS report contrasts with testimony Federal Reserve Board Chairman Ben Bernanke gave to Congress yesterday. "Our assessment is that there's not much indication that subprime issues have spread into the broader mortgage market," Mr. Bernanke said.'

So, how big is the problem? The Journal reports that there are at least $400 billion worth of Alt-A mortgages that were "were originated last year, up from $85 billion in 2003, according to Inside Mortgage Finance, a trade publication. Alt-A loans accounted for roughly 16% of mortgage originations last year and subprime loans an additional 24%." That means that, theoretically speaking, up to nearly one-half of the mortgages originated last year might be at risk of default.

And as of right now, the problem seems to be somewhat contained, as "despite the uptick in bad loans, the problems in the Alt-A sector aren't as severe as those that have roiled the subprime market. Some 2.4% of Alt-A loans are at least 60 days past due, according to UBS, which looked at mortgages that were packaged into securities and sold to investors. That is well below the 10.5% delinquency rate for subprime mortgages."

But, the trend seems to be accelerating as "Some borrowers who took out Alt-A loans in recent years are starting to feel the strain. Johnny and Shirley Johnson, retirees in Cleveland, took out an option ARM when they refinanced their $92,700 mortgage in July 2005. The loan carried a 3.5% introductory rate that began moving upward a few months later. The couple, who live on a fixed income, are currently making the minimum payment on their loan. But they are afraid they won't be able to keep up with their loan and other debts once their monthly mortgage payment adjusts upward later this year."

Indeed "Housing counselors and bankruptcy attorneys say they are seeing an increase in troubled borrowers who previously had good credit. "

The anecdotal evidence clearly supports that more trouble that is currently evident is clearly on the way: 'Thomas Gorman, a bankruptcy attorney in Alexandria, Va., says he is seeing more financially strapped borrowers who "probably bought more house than they could afford and then took on more credit-card debt" to furnish the house and pay for the move. When the housing market cooled, they were "caught in the middle," unable to sell their home or refinance and make their debt load more manageable.'

According to Reuters, "U.S. banking regulators plan to issue eagerly awaited guidance on the sub prime mortgage market as early as Thursday afternoon, two sources familiar with the matter told Reuters on Wednesday."

The wire service added: "At issue is whether regulators will force lenders to qualify subprime borrowers based on their ability to make the highest possible monthly payments during the life of the loan, instead of the initial lower rate, according to banking experts. The additional guidance on subprime mortgages will come at a time when rising delinquencies have reverberated throughout U.S. financial markets. A growing number of sub prime borrowers face foreclosure and their lenders face insolvency."

In fact, it looks to us as if the mortgage sector is starting to get squeezed from all sides. Reuters reported: "No. 2 mortgage buyer Freddie Mac (NYSE:FRE - news), in a move seen as front-running regulators, on Tuesday said it would stop buying most sub prime loans as sold today and introduce its own product for lenders to offer to their riskiest customers. Freddie's decision was criticized by the mortgage industry's main trade association, which said it would restrict credit to borrowers at a time when lenders saddled with rising delinquencies are already tightening guidelines."

Conclusion

Every bull market has its unraveling, as the driving force of the rally loses steam. The post 9/11 bull, that started in 2003, as the S & P 500 bottomed, was fueled by record low interest rates, and a subsequent housing boom.

As speculation rose, so did the risk, and now we are starting to see the unwinding. The bottom of the curve always goes first, as we've seen with the sub prime mortgage sector.

Now, the risk is spreading to the middle of the curve, and it is doing so at a time when the second pillar of the bull market, China, is starting to show signs of weakness.

This, brings us back to an article we penned in April 2005, titled "Rate Hikes May Create 'Perfect Storm" In the article we described a chain reaction: "If U.S. households find themselves in a cash flow crunch, as a result of rising mortgage rates, and the Chinese economy is suddenly drained of foreign cash, being repatriated to the United States due to the lure of rising interest rates, a significant change of scenario in the markets is not just likely, but inevitable. The shift could start suddenly, and progress quickly, fueled by fiber optic communications and the flow of information at the speed of light."

So far, this week, we saw China stumble, while the U.S. housing market continues to weaken, and risk is starting to spread through the mortgage curve. Oil has already cracked, although it is making a rebound.

And here's the clincher from the Journal: "investor concerns about Alt-A loans are rising, according to Walter N. Schmidt, a mortgage investment strategist at FTN Financial Capital Markets in Chicago. A report from mortgage analysts at Barclays Capital in New York this week pointed to fraud as one reason for early defaults on Alt-A loans. The mortgage industry is battling a rash of cases in which borrowers, loan officers and appraisers collude in providing false information to induce lenders to advance more money than homes are worth."

Shocking isn't it? Fraud at the height of a bull market - reminds of that little Enron episode a few years ago.

To us, it just seems that the Fed, the mortgage industry, and the Chinese government are all whistling past the graveyard on this.

Joe Duarte, M.D.

Joe Duarte M.D. is founder and Editor in Chief of Joe-Duarte.com. Dr. Joe Duarte's Daily Market I.Q. is a premium service that provides daily intelligence, trading strategies, and technical analysis at www.joe-duarte.com. Duarte offers free analysis and news coverage at www.intelligentforecasts.com . Dr. Duarte is a board certified anesthesiologist, a registered investment advisor, and President of River Willow Capital Management. He is author of "Successful Energy Sector Investing" and "Successful Biotech Investing" (Prima/Random House). Duarte's analysis appears regularly in major outlets including CBS MarketWatch and Investor's Business Daily.