The NYT reported recently that New York prosecutors are investigating whether Wall Street banks withheld information about the risks stemming from subprime loan-linked investments:

Citing people with knowledge of the matter, the newspaper said the inquiry, begun last summer by state Attorney General Andrew Cuomo, was focusing on how banks bundled billions of dollars of exception loans and other subprime debt into complex mortgage investments.

Charges could be filed as soon as the coming weeks, the Times said. Connecticut Attorney General Richard Blumenthal told the newspaper he was also conducting a review and cooperating with New York officials.

The federal Securities and Exchange Commission is also investigating, the Times said.

Reports commissioned by Wall Street banks raised alerts about the high-risk loans, known as exceptions, which fell short of even the lax credit standards of subprime mortgage companies and the Wall Street firms, the newspaper said, but the banks failed to disclose those details to credit-rating agencies or investors.

Hmm, exception loans? Loans that fell short of even the lax credit standards of Subprime mortgage companies? I guess nothing should surprise me when it comes to Subprime, however, I was not aware that one can even lower the credit standards further. How low can you go and how many of those beauties were created?

Industry officials say the so-called exception loans make up anywhere from 25 percent to 80 percent of the $1 trillion subprime mortgage market among portfolios they had seen, the Times said.

The banks also failed to disclose how many exception loans were backing the securities they sold, with underwriters using such words as “significant” or “substantial,” securities law requires banks to disclose all pertinent facts about securities they underwrite, the report said.

OK, so they did not disclose the percentage. Really, do you think that with the then gold rush mentality anybody would have cared?

My issue with this is that there seems to be always new twists appearing and this may not have been the last one. What this means is that the fallout from the Subprime crises will be (unfortunately) with us for quite some time to come.

With some of the largest troubled financial companies (Citibank, Merrill Lynch) hunting the world for investment dollars, you’re probably wondering what terms they need to offer to get someone to come aboard and part with many billions. Apparently, learning from BofAs ill-timed original investment in Countrywide, the rules of the game seem to have changed.

Mish Shedlock at Economic Trend Analysis explains the use of “ratchet provisions.” Here’s the article he references:

In the terms for both the Merrill (MER) and Citigroup (C), convertible transactions are “ratchet” provisions. For those not familiar with the term, when an issuer agrees to a ratchet, it gives the security holder the right obtain better terms in the future under certain conditions.

Shareholders in troubled financial services companies should not take this lightly.

Hmm, I can’t help but think that giving terms under these conditions adds a smell of desperation…

With yesterday’s market drubbing, the bears came out ahead and influenced our Trend Tracking Indexes (TTIs) as well. Our International TTI headed further south (-8.24% below its long-term trend line) thereby confirming our sell signal from 11/13/07.

While the Domestic TTI is technically still in Buy mode (+1.66% above its long-term trend line), we’re not adding new positions as announced in my weekly StatSheet. Some readers have asked if I think that country funds will buck the current down trend here in the U.S.; the answer continues to be no. If the domestic market declines, the rest of the world will follow. You can easily verify this by looking at the performance of country ETFs in the most recent StatSheet.

As of last week, there were only a couple of countries that showed strong momentum numbers, and they have weakened since.

Current market strength can only be found in selected sector and bear market funds/ETFs, and I suggest cautious use since trends in the current environment can turn and end in a hurry.

Yesterday’s market rebound had the bullish crowd finally doing some chest pounding after the downturn of the past 2 weeks. Does this mark a turn in the market place or will the bulls remains in hibernation?

Bill Fleckenstein had this to say in his article titled “We’ve run out of bubbles:”

I’ll begin the New Year with this comment: There are no bullish interpretations for the stock market’s action thus far. This tells us that 2008 will be the year when reality finally overtakes the Goldilocks crowd.

If we stop attempting to bypass the creative destruction of capitalism, we will finally be able to bring about a recovery built on a solid foundation instead of the quicksand underlying the 2003-07 “recovery” that was built on the housing mania. Though I would like to think the politicians and the Fed get the message and will let the process play out, I am not going to hold my breath.

Bill offers other interesting thoughts, and I suggest that you read the entire article. If you’re looking to add gold to your portfolio, you may want to examine his arguments on “why gold is going higher.” Again, this is just one opinion and is not to be confused with a recommendation to buy.

I was just as surprised as anybody else when BofA announced an agreement to take over troubled mortgage lender Countrywide. As you may recall, BofA had made a $2 billion investment last year, when the stock price hovered around $18. Why would they now throw good money after bad?

Some analysis I read offered the thought that maybe the Fed had something to do with that, since rumors were swirling that Countrywide was heading towards bankruptcy. Having the largest mortgage lender in the country go bankrupt would certainly have other repercussions. To me, one big one would be how regulators would sort through the 9 million mortgage payments that Countrywide collects every month.

Columnist Herb Greenberg had this to say in his blog:

1. The Fed is behind the deal.
2. The Fed is behind the deal because the rumors yesterday of a near bankruptcy were probably true.
3. As part of the deal, the government likely agrees to guarantee BofA against Countrywide-related losses.
4. Lost in the in the noise yesterday was that Moody’s downgraded the ratings on 30 (count ‘em — THIRTY!) tranches of Countrywide’s mortgage debt by more than a few notches. They did something similar before American Home Mortgage filed for bankruptcy.
5. Investors bid the stock higher assuming a premium when it’s likely that BofA still needs to fully assess the value of the assets before the deal’s full value will be known.
6. Big question, of course, is what Countrywide investors will get.
7. Rule of thumb with bankruptcies: Stocks often double on their way to zero.
8. BofA gets a free bank and a put to the government.

No matter what the real reason, given the fact that the credit/Subprime/housing crisis continues to spread, this “takeover” looked like an act of desperation to me in order to avoid the first direct bankruptcy casualty. If others can be avoided remains to be seen.

Some time ago, I came across an interesting website dealing with the analysis of the California, and at times nationwide, housing market.

The site is appropriately named Dr. Housing Bubble and, in a recent article (12/26/07) it featured a special edition titled “Real State of Genius: Today we Salute you California with Our Real Home of Genius Award! 10 Homes throughout the Golden Bubble State.”

Here’s a snippet:

Happy holidays everyone! Hope everyone is enjoying the end of the year festivities. There’s a feeling in the air that everyone is maxed out. I was out in the Inland Empire this past weekend and saw very nice brand new homes going for $200,000. Prices are starting to take major downturns here in California. I’ve been getting a lot more e-mails from readers showing me Real Homes of Genius throughout the state. In fact, I would venture to say that this housing fiasco has enveloped the entire state of California into a Real State of Genius.

If you have any doubts that we are in a bubble here in California, after seeing these 10 homes maybe your opinion will change. We’ll profile homes in posh areas, to not so prime areas to demonstrate that this manic housing bubble infected rich and poor alike. Greed crosses all socio-economic barriers. California is the golden state and land of Hollywood. Perfect weather and tan bodies are everywhere; that is if you are within a 10 mile radius of the coastline. Yet homes that are nowhere near the coast and have bad weather went up in price just like prime properties. It would seem that being in California was justification enough for sky-high prices. Today we salute you California with our Real State of Genius Award.

Read the full article to see pictures of the featured shacks and their price histories. If you’re not living in California, you will be simply amazed at the overpriced turkeys presented here. With no more Subprime borrowers and teaser financing available, there is only one direction for these home prices to go—and that is down.

Several readers have asked if we are currently in a debt or liquidity crisis, or both. Minyanville’s Kevin Depew had an excellent write-up explaining the differences. Here is an excerpt:

Here is an interesting data point that many may not have noticed. Since the Federal Reserve Open Market Committee began lowering interest rates on Sep. 18, the S&P; 500 has declined more than 7%. For those that have noticed the decline, particularly the decline in shares of Financial stocks as the PHLX Bank Index (BKX) has plummeted by 24% since Sep. 18 – a bear market by any measure – the most frequently asked question is “Why isn’t the Fed’s liquidity working?”

“Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit – this is called a fractional reserve banking system – if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the bank does not have enough cash on hand to satisfy the demand from its depositors.
The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn’t matter how much liquidity the Fed provides, the bank will go bankrupt.”

Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little value and income generation. As a result, time preferences are retreating, risk aversion is growing, and access to credit is diminishing.

If this subject fascinates you, I suggest you read the entire article. As always, Kevin makes his points succinctly and easily understandable even for the lay person.