You know you have a serious problem with subprime-related CDOs and the housing and mortgage markets when mainstream analysts compare CDOs and mortgage backed securities to “subslime”, “toxic waste” and “six-inch hooker heels”…

The conservative Kudlow had a heading in his show last nite that referred to CDOs and to the Bear Stearns CDO scandal as “subslime”: indeed now it is not just an issue of the two failing Bear hedge funds but also the apparently sleazy or “sub-slime” Everquest scandal.

At  the same time the most reputable financial guru Bill Gross (the head of Pimco, the biggest bond fund in the world) referred to CDOs as “six-inch hooker heels”, “tramp stamp” and “toxic waste”. In his monthly note published this week Bill Gross sarcastically referred to the ratings (better call them “mis-ratings”) of the CDOs by the credit “rating” agencies as follows:

 “AAA? You were wooed Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels, and a “tramp stamp.” Many of these good looking girls are not high-class assets worth 100 cents on the dollar. . And sorry Ben, but derivatives are a two-edged sword. Yes, they diversify risk and direct it away from the banking system into the eventual hands of unknown buyers, but they multiply leverage like the Andromeda strain. When interest rates go up, the Petri dish turns from a benign experiment in financial engineering to a destructive virus because the cost of that leverage ultimately reduces the price of assets. Houses anyone?… 

AAAs? Folks the point is that there are hundreds of billions of dollars of this toxic waste and whether or not they’re in CDOs or Bear Stearns hedge funds matters only to the extent of the timing of the unwind. To death and taxes you can add this to your list of inevitabilities: the subprime crisis is not an isolated event and it won’t be contained by a few days of headlines in The New York Times… 

Because the problem lies not in a Bear Stearns hedge fund that can be papered over with 100 cents on the dollar marks. The flaw resides in the Summerlin suburbs of Las Vegas, Nevada, in the extended city limits of Chicago headed west towards Rockford, and yes, the naked (and empty) rows of multistoried condos in Miami, Florida. The flaw, dear readers, lies in the homes that were financed with cheap and in some cases gratuitous money in 2004, 2005, and 2006. Because while the Bear hedge funds are now primarily history, those millions and millions of homes are not. They’re not going anywhere…except for their mortgages that is. Mortgage payments are going up, up, and up…and so are delinquencies and defaults. A recent research piece by Bank of America estimates that approximately $500 billion of adjustable rate mortgages are scheduled to reset skyward in 2007 by an average of over 200 basis points. 2008 holds even more surprises with nearly $700 billion ARMS subject to reset, nearly ¾ of which are subprimes… 

This problem — aided and abetted by Wall Street — ultimately resides in America’s heartland, with millions and millions of overpriced homes and asset-backed collateral with a different address — Main Street.” 

The fallout of this CDO mess is likely to end up into $100 billion plus of losses for banks, financial institutions, hedge funds and investors once these CDOs and subprime mortgage backed securities are marked-to-market rather than being marked-to-a-delusional-misrated-model. Thus, the Bear disaster is only the tip of the iceberg of a much bigger financial mess that will unravel in the next few months: the pile of rising subprime and nearprime delinquencies will take a toll on the toxic waste of mortgage backed securities that a rating “voodoo magic” pretended to turn below-junk securities into A-rated ones. 

But Bill Gross is indeed  also correct in pointing out that the source of this sub-prime slime and now CDO carnage is the biggest US housing recession in the last few decades. As if the bad news from the housing market in the last few weeks were not bad enough another batch of ugly news came out yesterday and today:  

-         home prices falling further (2.1% y-o-y) based on the S&P/ Shiller and Case index;

-         the biggest US homebuilder – Lennar - reporting large and unexpected losses for Q2 and worsening conditions for the rest of the year;

-         new home sales for May down again and previous months sales revised further downward.

-         mortgage applications falling 3.9% in the last week and 4.9% for purchase applications;

-         subprime delinquencies rising and the credit crunch in the subprime market getting worse The delinquency rate for subprime mortgages increased to 13.8% in Q1, according to the MBA, up from the already high 11.5% a year before.

-         near-prime Alt-A delinquencies are rising sharply: late payments of at least 90 days and defaults on 2006 Alt A mortgages have increased to 4.21 percent, up from 1.59 percent for 2005 mortgages and 0.81 percent for 2004 mortgages, as reported by S&P. So the subprime carnage is now spreading to near prime mortgages. 

No wonder that all these lousy news about housing and gasoline prices sky high have depressed the US consumer with consumer confidence now significantly down. And no wonder that the latest news from retail sales are also lousy. As reported by the International Council of Shopping Centers and UBS in the last two reporting week same store chain store sales have been down (-0.7% in the last week) while the year-over-year growth rate of such sales is now down to 1.7% (i.e. falling in real terms relative to a year ago). Add to that a 2.8% fall in durable goods orders for May and a survey of major CFOs suggesting that they are planning to cut capex spending and accumulate less inventories. 

Blood bath in the housing market, turmoil in financial markets and rise in credit spreads, risks of financial contagion, subprime credit crunch now spreading to other parts of the mortgage market, plunging consumer confidence, falling retail sales, falling capex investment by the corporate sector: it looks fugly and fuglier for the financial markets and the real economy. In Q1 we had already a “growth recession” with GDP growth at a dismally low 0.6%; Q2 may be slightly better but the outlook for second half of 2007 looks pretty ugly. The growth recession of the last quarter is highly likely to persist throughout 2007 with the risks of an outright recession being still high.