Fresh from being singled out by the Wall Street Journal as “the man who saw it coming”, CLSA’s Christopher Wood in this week’s issue of his client newsletter Greed & Fear marvels at the wilful blindness of stock market investors and looks to the great unwind of structured finance.

“It remains apparent,” he says, “that stock-market investors do not want to believe in bad stories. This is why stock markets keep falling when presented with such newsflow, even if the news should not surprise and, therefore, should be discounted.”

The trend, he says, is clear from Wall Street’s reaction to the latest house-price data on Tuesday. Thus, the S&P/Case-Shiller US National Home Price index fell 3.2 per cent year-on-year in the third quarter, the biggest annual decline since the series began in January 1987. Moreover, 15 of the 20 metro-area sub-indices posted negative annual returns.

Greed & Fear still believes that the newsflow on housing will continue to deteriorate for the rest of this calendar year, which means that house prices could be declining on an annualised basis by a high single-digit percentage by the end of 2007. This may still not be a disaster for the macro economy but it will be a disaster for the mortgage-backed-securities market because of the leverage embedded in it.

But the real story, says Wood, remains “the exposure of the whole structured-finance industry as a collective endeavour to disguise risky credits as safe credits”. This revelation will expose the western financial-services industry to heavy regulation, he warns:

The upcoming unwinding of structured finance is also a big-picture deflationary deleveraging event, which is why the risks to the US economy remain all on the downside.

More and more banks are being forced to admit to having set up special investment vehicles, or “conduits”, off-balance sheet, he notes. “A lot of dodgy securitised debt is now being put back to them,” he says, advising investors to “fundamentally underweight all the financial plays globally that have been making their money in this fashion”. The main risk in this stance is an escalating moral hazard generated by central-bank actions, he adds.

In Wood’s view, “there can be no justification for central banks lending against CDOs and the like. This is as clear an example as any of where financial players should be made to pay the free-market consequences of their willingness to indulge in excessive risk-taking”.

Greed & Fear’s guess going forward is that the more pressing issue occupying US politicians will be Main Street, not Wall Street. Once it is accepted that the housing sector is a disaster, then Washington’s attention will be focused on how to help distressed mortgage borrowers, not how to bail out owners of mortgage-backed securities.

Investors, according to Wood, should keep a close eye on the political debate in Washington in coming months: “With a presidential election next year, both major parties will have to be seen to be doing something if the housing slump intensifies, as Greed & Fear anticipates.”

But pain on Main Street also makes regulatory actions against all things related to structured finance “even more inevitable”, notes Wood. “For without structured finance, the house-financing bubble would never have become so extreme, nor for that matter would have the LBO ‘private-equity’ bubble, the negative consequences of which will be heard more about next year after the economy has slowed.”

This entry was posted by Gwen Robinson on Friday, August 31st, 2007 at 11:26 and is filed under Uncategorised. Edit this entry.