Credit Crunch Still Has a Ways to Go

Like most investors, I'm delighted when markets rise — even when, for the life of me, I can't figure out why. Until last week, that's how I was feeling. Since the market bottomed on Aug. 16, in the midst of a credit meltdown and market turmoil, it had soared to new highs. It was as if Fed Chairman Ben Bernanke had pulled out a magic wand, waved it to produce a half-point rate cut, and poof! The credit crisis was gone.

Then came Friday's 366-point decline in the Dow Jones Industrial Average, which ended the week down over 4%.

Meanwhile, mortgage defaults — the problem at the heart of the credit crisis — have continued to soar. The New York Times reported that defaults on adjustable rate mortgages written in the first half of 2007 reached 8.05% in August, up from 5.77% in July, and significantly higher than comparable loans written in 2006. Thornburg Mortgage (TMA), the mortgage REIT whose fortunes I've followed closely in this column, reported a $1 billion loss and suspended its dividend, sending its stock to new lows for the year. The owners of CDOs — collateralized debt obligations — have begun getting notices that some of their interest payments are being suspended, the Times reported. There are $486 billion in bonds backed by mortgages outstanding, issued in 2006 and 2007 alone. And if we weren't already drowning in acronyms, now we have to confront SIVs — Structured Investment Vehicles — which are in such dire straits that major banks had to patch together a bail-out fund. There are $320 billion in such vehicles outstanding.

For further evidence of the continuing deterioration in credit markets, look no further than last week's earnings from JPMorgan Chase (JPM), Citigroup (C), and Bank of America (BAC). It says something when JPMorgan's Jamie Dimon is hailed for managing to offset $1.3 billion in write-downs with $1 billion in private equity and other gains; overall profits rose 2%. Citigroup, where profits fell an alarming 57%, wrote off $1.56 billion in CLOs alone (there's another acronym — collateralized loan obligations) and $600 million more than it had forecast just two weeks earlier. And Bank of America, which was supposed to be inoculated from credit woes by its big consumer franchise, reported a stunning 93% drop in investment banking income, to a measly $100 million. Earnings were down 32%, missing analysts' estimates. (I was among the disappointed, since I own Bank of America shares.)

And these earnings are necessarily backwards looking. It's still too soon to know how the continuing deterioration in housing and mortgage markets will affect future banking profits. Will the recent deal-making frenzy continue? Will the private-equity boom roll on? Maybe. Then again, maybe not.

As I've said before, I don't expect much visibility in the mortgage market before the end of the year at the earliest. The latest developments once again underscore that this is a slow-moving crisis. It cannot be resolved with a few write-downs and a rate cut or two. Many traders can live with anything but uncertainty. Yet uncertainty is our fate for the immediate future.

So what does this mean individual investors? Here's my take:

I'm not in the camp predicting recession. Generally overlooked in Caterpillar's (CAT) earnings report last week was its glowing account of overseas growth. The global economy still looks terrific. But there are times to be cautious. With so many unknowns lurking within the financial system, this strikes me as one of them.