Article originally submitted to subscribers on 4th March 2007...

How deep is the Rot?

That's the questions the markets are asking right now.

How serious a Credit Problem lies ahead?

It's uncanny how sentiment overrides all.

Debt creation has been on an absolute tear.
Mortgage debt, Private Equity debt, Central Bank debt, Derivative debt, you name it, every area of the economy is overrun with debt.
Asset markets have been floating higher buoyed by debt.
And yet, nobody has ever stopped to ask the question, what would happen when the party stops?

Looks like we're finding out.

Its public knowledge that sensible lending practices were tossed out the window when it came to sub-prime mortgages. All a mortgage lender had to do was get a warm body into a home and let the price appreciation do the rest. There was no need for a down payment, an income test, an asset test or even for the homeowner to pay full monthly payments - interest only would do - house prices were rising so quickly that all those pesky inconveniences were pushed aside.

But then the music stopped!

Chart 1 - Sub-prime lender New Century down 66% on a Waterfall decline

But that's only the marginal borrowers the chorus rang out!
The fundamentals are still sound in the prime mortgage market.

Well, let's discount for a second the fact that over 20% of mortgage lending was sub-prime last year. And lets assume that such carnage could be contained, the above statement is by and large correct.

In September 2006 I wrote an article about the two-tier nature of the Australian residential Real Estate market. (Australia had been leading the US by about 3 years). That is, the equivalent of the sub-prime market in Australia was under extreme pressure and yet the more affluent areas were still appreciating. That's what we've been seeing play out in the US.
Prices in financial centres like New York have continued into the stratosphere whilst non-financial centres such as Atlanta have softened quite a bit.

But hold on, it looks like that tune is about to come to an abrupt halt!

Chart 2 - Bellwether Merrill Lynch falling on volume

If the financial stocks are beginning to feel the pinch, so will real estate in those areas.

---

Last weeks market weakness came literally out of the blue. There was no newsworthy item which suggested last week had to be the week. The media suggested the Chinese government were to blame. Apparently they had been meddling in the Stock Market, attempting to apply the monetary breaks. This in turn sent stocks tumbling across the world.

Yes, I am sure there is truth to that. But why is nobody mentioning the failing US consumer or the reversal in the Yen Carry trade or how about the constant internal market erosion week after week? Has the media suddenly declared China more important than the US? Is that how rapidly power transfers?

Regardless, sentiment has reversed so quickly that one can see or even feel how a panic can overcome the market and good fundamentals become completely ignored.

Talking about ignored, the investment world has yet to turn en masse to safe havens such as Gold or the Swiss Franc. This suggests we are still early into this market decline.

Gold was unceremoniously dumped along with the rest of the market in a flight to Cash and Treasuries. And whilst it's not possible to tell if this decline has further to go (I suspect it has), sentiment will once again turn in Gold's favour as declining asset prices expose the extent of the vast credit problems.

The answer is that the rot may be much more widespread than is commonly acknowledged.

Hold on to your hats!

More commentary and stock picks follow for subscribers...