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November 30, 2007

Subprime Delivers One-Two Punch Just Like Hurricane Katrina Did
by Susan Walker

The world is awash in bad news about the subprime mortgage meltdown, just the same way that New Orleans was awash in floodwaters from Hurricane Katrina two summers ago. A few examples:

• The median price for new home drops 13% since last year, the most in 37 years, according to a Census Bureau report on November 29. This due in large part to buyers not being able to get financing now that lenders have tightened their lending standards in response to the subprime debacle.
• Major Wall Street banks write off billions of dollars in subprime-backed securities.
• Dire forecasts estimate that the credit crunch caused by the mortgage problems will cause between $250 billion to $500 billion of losses at banks and brokerages before it's done.

If you want to see how this kind of news looks on a price chart, consider the chart that we published in the latest Elliott Wave Financial Forecast. It shows how confidence in the mortgage market has simply fallen off a cliff. "The ABX Mortgage Indexes are akin to the eerie music that starts to play right before the goriest scenes in a horror movie," write our analysts Steve Hochberg and Pete Kendall. Even prime-rated mortgages (the top line on the chart) seem to have been tainted by the cliff-diving exploits of the subprime and Alt-A mortgage indexes.

Editor's note: Elliott Wave International invites you to read more about this Mortgage Mutiny chart in a special three-page excerpt from the November 2007 Elliott Wave Financial Forecast, called "Transition to a Fear of Risk."

The continuing repercussions of the subprime meltdown since two Bear Stearns' hedge funds imploded in August remind me how closely this situation imitates the delayed punch of Hurricane Katrina in the summer of 2005. In fact, I wrote a column for Fox News on that very topic a few months ago, some of which is worth repeating.

* * * * *
[Excerpted from "Subprime Storm Mimics Katrina," originally published 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.

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 for those in the Big Easy to breathe easy. 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. Now, Wall Street is having trouble selling more debt. 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.

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.

* * * * *

Now, here we are at the end of November, and the situation for investors and investment banks has played out almost exactly as I outlined. Hardly anyone is coming out smelling like a rose. If anything it's the opposite, as the stench from quarterly financial filings rises as banks reveal how many billions in dollars they must write off for their mortgage investments gone bad. Sadly, the conclusion to my Subprime Katrina column still 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."

Susan C. Walker
Elliott Wave International

Susan C. Walker writes for Elliott Wave International, a market forecasting and technical analysis company.

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