The Best of Doug Kass

The self-proclaimed "anti-Cramer," Doug Kass, anchors Street Insight's "The Edge," a diary about stocks and investing. As a dedicated short-seller, Kass can seek out the bear market in any environment.

This week, he discussed ten factors that could move stocks, the impact of subpar subprime lending and a quiet problem for subprimes.

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Ten Things That Could Move Stocks
Originally published on 2/5/2007 9 a.m. EST

Every few weeks, I recap 10 tidbits I've picked up from trading desks and other industry sources. These items have not been confirmed, but either have affected, or could affect, the stocks mentioned. The first such column, in early January, proved prescient on several fronts. Here are this week's top 10.

1. Apple's (AAPL Quote) Steve Jobs' problems regarding option grants run much deeper than is generally assumed. I am hearing that Jobs has personally hired a high-powered law firm in his own defense, and that the odds increasingly favor action by the SEC and the U.S. attorney's office.

As well, a recent regulatory filing by Apple filled with audacious statements ("The company intends to continue full cooperation ... the resolution of these matters will be time-consuming, expensive and will distract management from the conduct of the Company's business") has incensed the two aforementioned government bodies as well as certain members of Congress. I am also hearing that Google(GOOG Quote) CEO Eric Schmidt has already begun low-level discussions with several Apple board members regarding his role as a possible temporary replacement to Steve Jobs should the options-backdating issues intensify at legal levels.

2. Earlier this month, I heard (correctly) that the low-end cellular-phone market "has been jammed with inventory as demand erodes ... guidance will be lowered by the leading manufacturers as margins erode and average selling prices continue to fall."

Since then Motorola(MOT Quote), Nokia(NOK Quote) and Ericsson(ERIC Quote) have disappointed and guided down profit forecasts. Now I am hearing that the high-end market has weakened abruptly over the last three weeks, and more estimate revisions are in the offing.

3. In January, I also had heard that Dell(DELL Quote) would guide lower. Indeed, Dell missed, and Michael Dell has seized back operating control of the company from Kevin Rollins. I am now hearing that Dell -- in conjunction with Microsoft(MSFT Quote) -- is working on a SideShow-enabled MP3 player that will sport media capabilities along with wireless connectivity and will offer almost unlimited types of data that the SideShow platform is capable of displaying.

4. I also am hearing that Microsoft is planning the introduction of a Zunephone by Christmas 2007. Designed to compete with the iPhone's midyear entry, the effort is being managed by J. Allard (one of the chief architects of the Xbox), who recently replaced Bryan Lee as the head of Zune's operations.

5. I continue to hear the subprime carnage is accelerating. Several of these firms are believed to be close to shutting their doors.

6. Deals I hear that are imminent include the combination of Sirius Satellite(SIRI Quote) and XM Satellite Radio(XMSR Quote); Unilever(UN Quote) and Richardson-Vicks; IBM(IBM Quote) and SAP(SAP Quote); and private-equity takeovers of the following:

Nabors Industries(NBR Quote)
Novellus Systems(NVLS Quote)
Novelis(NVL Quote)
Bristol-Myers Squibb(BMY Quote)
Business Objects (BOBJ Quote)
Nvidia(NVDA Quote)
Triad Hospitals(TRI Quote)
Gaylord Entertainment(GET Quote)
Qwest Communications(Q Quote).

7. While nary an analyst has mentioned this development, Nielsen/Net Ratings' reports for December 2006 reveal that Google's search business (+22.6% year over year) is growing more slowly than Yahoo's!(YHOO Quote) search (+30.1%).

For the full year, Google gained 560 million users (down from 1.06 billion the year before) and Yahoo! gained about 330 million users (down from 370 million users a year earlier). Although Google's search-share approaches 51% (compared with only 23.6% for Yahoo!), I am hearing this trend has not fallen on deaf ears as Google is planning some senior management changes in February, which will surprise investors and analysts.

8. Speaking of Google, both YouTube and its parent company are now aggressively adopting strategies of paying for content (broadcasts, videos, etc.). I am hearing investors should look for alliances with consumer-created content companies (C4s) similar to the models of Threadless, Eefoof and Revver, and watch for a progressive rise in Google's cost of goods -- both absolutely and as a percentage of revenue -- in coming quarters.

9. I am hearing that, at the urging of Prince Alwaleed bin Talal (Citigroup's(C Quote) largest individual shareholder), former Bank of America(BAC Quote) CFO Al de Molina has already been contacted by members of Citigroup's board of directors regarding naming him as a possible replacement to Charles Prince. At the same time, I am hearing that JPMorgan's(JPM Quote) Jamie Dimon has informally approached Citigroup's Sallie Krawcheck for a senior position within his bank.

10. Finally, I am hearing that conversations regarding an alliance or merger between Toyota(TM Quote) and Ford(F Quote), though dismissed publicly, have proceeded apace in 2007.

At time of publication, Kass and/or his funds were short the SPY, although holdings can change at any time.

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Subpar Subprime a Growing Problem

Takeover Rumors Abound
2/8/2007 10:03 a.m. EST

Rumors of takeovers of OfficeMax (OMX Quote) and Circuit City (CC Quote) abound on trading desks today, which could explain the higher moves in the stock - OMX up about 5%, and CC up about 4%.

Fungus Among Us
2/8/2007 8:35 a.m. EST

Over the last several months I have been writing on Street Insight and talking on CNBC's "Kudlow & Co." about the ramifications of the developing implosion in the subprime mortgage market.

Last night there was more evidence: HSBC Holdings (HBC Quote) and New Century Financial (NEW Quote) -- two of the three largest subprime mortgage lenders in the U.S. -- reported disastrous credit losses stemming from their real estate origination businesses.

HSBC announced that its allowance for bad debts will rise to $10.6 billion (more than $1.75 billion above estimates) and New Century (whose stock fell nearly 20% on the news on Wednesday evening) projected a fourth-quarter loss and the need to restate its prior quarters because it materially understated subprime delinquencies and foreclosures.

Nationwide, the subprime default rate soared to 10.09% in November 2006 -- it stood at only 6.62% a year earlier). Despite a growing economy in early 2007, November's industry default rate exceeded the level of November 2001, which was recorded at the bottom of the last recession. However, the problem runs deeper than 5 1/2 years ago because nearly 15% of the mortgages made in 2006 were subprime. That is almost triple the penetration of subprime compared to 2000-01.

Making matters worse:

• Subprime has never been more levered -- just as the housing cycle has peaked. Loan-to-value ratios have risen from about 78% in 2000 to 86% today.
• Subprime has never been more dependent on the candor of borrowers. Low-documented loans have doubled to 42% of subprime loans over the last six years.
• Creative loans -- non-interest paying, option ARMs, etc. -- represented nearly half of all loans made over the last 12 months. At the turn of the decade these loans represented less than 2% of total mortgage loans!

Before the extraordinary start in home-price appreciation six years ago, bank charge-offs for home mortgages peaked at 45 basis points. If we simply move to that level again (and considering the above three factors, this seems reasonable), that would imply more than $40 billion in charge-offs.

However, given the alarming swiftness in recent foreclosures and delinquencies, debt downgrades of subprime pools and looser standards that accompany mortgage loan "innovation," it is hard to believe charge-offs won't exceed the 2001 levels.

Many have dismissed the subprime risk, even though originators like Sebring Capital and Ownit Mortgage Solutions were filing bankruptcy in late 2006 faster than you could say "five-year balloon mortgage."

For that matter, many other economic risks also have been dismissed, including the bubble in credit availability, a spent-up consumer, tightening labor markets and lower productivity, the rising CRB RIND Index and the attendant cost-push inflation.

Also dismissed are the bubble in emerging markets, a levered and vulnerable (long-biased hedge fund and fund of funds (especially of a Swiss-kind) industries, the broad and negative tax implications of the Democratic tsunami and a more hawkish Federal Reserve than many expect as being compartmentalized with little chance of a broader contagion.

After all, an investor base immersed and captivated by "Cramerica" sees no evil and hears no evil, as the market just chugs along ever higher (13 out of the last 14 months have boasted positive returns).

That fungus of subprime credits is now clearly not only among us but it is now upon us, and the implications for a tightening in mortgage credit will likely serve to contribute to the second leg down in housing over the balance of 2007.

The tidal wave of liquidity and cheap borrowing over the last seven years -- which has permeated the mortgage, private-equity and stock markets -- has created an attitude toward risk-taking unlike almost anything ever seen before.

Except for a brief period in late 1999-early 2000, the spread of risk taking to risk aversion has never been wider. Like eight years ago, this condition has produced a market that is currently priced for perfection, poorly positioned for any unpleasant surprises.

We entered 2006 with most investors holding the highest degree of confidence in rising prices for their homes. As it turns out, homeowners were materially disappointed last year.

We enter 2007 with investors having the highest degree of confidence in rising prices for their stock holdings. They too might be disappointed as the year progresses when the hidden fragility of an overpriced, overleveraged world will soon be revealed.

I have written that "in time we will undoubtedly see a mean reversion in home prices, interest rates, credit spreads (and losses), corporate profit margins ... and in the world's equity prices."

Last night's subprime mortgage news that credit losses are skyrocketing is the first shot across the bow of the boat called market optimism.

At time of publication, Kass and/or his funds had no positions in stocks mentioned, although holdings can change at any time.

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Ratings Are Subprime's Dirty Secret
Originally published on 2/9/2007 9:30 a.m. EST

The little-known secret in the subprime market is that the ratings agencies have been lax in their downgrades of subprime paper. The recalcitrant agencies -- Moody's(MCO Quote), Fitch and Standard & Poor's -- have quietly abetted (blessed) the mushrooming of very aggressive subprime lending that has allowed the Wall Street firms selling these mortgage products to prosper.

According to Jim Grant, the number of downgrades at Moody's, for example, were even with upgrades in 2005. Last year, the downgrades/upgrades ratio rose slightly to 1.19:1. The problem is that the historical downgrade/upgrade ratio stands at 2.5:1!

Up to now, lenders (and borrowers) have greased the subprime market -- making it the swiftest-growing portion of residential real estate lending from 2001 to 2007. Lenders relied on the candor of the borrowers -- as nearly half of the subprime mortgages originated last year were low or undocumented.

Here is an example of the relaxed behavior of the agencies. This week's Grants Interest Rate Observer calls attention to a 13-month-old, $350 million asset-backed pool of mortgages, MABS 2006-FRE1. Foreclosures now stand at 9%, delinquencies at 10.5% and real estate owned at 3.5%. In other words, about 23% of the loans are problematic -- and neither Fitch nor S&P has downgraded the issue. No doubt investors in MABS 2006-FRE1 (hedge funds, brokerages, institutions, etc.) mark the issuance to par (since it has not been downgraded).

But what will happen when the ratings agencies finally downgrade MABS 2006-FRE1? (Which seems inevitable, but late!) Answer: Investors will sell.

Anyone for a 60-bid?

The subprime fungus has only recently been uncovered, and the seriousness of the problem for the sector of housing that has stirred the drink of the residential real estate market has only recently been uncovered in the "see no evil, hear no evil" capital markets of 2007. (Indeed, over on RealMoney, Jim "El Capitan" Cramer argues that the subprime woes are a good thing, because the carnage will contribute to a Fed rate cut. I view this as highly unlikely but consistent with the Cramerica psyche that has inundated the investment community -- good news and bad news are both treated favorably.)

What is astonishing to this observer is the almost universal view that the prime market is in good shape and that the weakness in subprime will be contained.

It will not be isolated, as nearly as half of all the mortgages made over the last 12 months -- even to prime customers -- are nontraditional, creative loans (interest-only, adjustable option ARMS, negative amortization, etc.). These, too, are vulnerable. At the very least, today's lemmings (a.k.a. mortgage lenders) will begin to restrict lending and will dramatically tighten standards. And Katie bar the door if this economy doesn't perform in a Goldilocks fashion.

The subprime mortgage news this week is the first shot across the bow of a boat called Market Optimism. Throughout the balance of 2007 and into 2008, mortgage defaults will accelerate into the prime market (as a result of a moderating economy, too-leveraged mortgage instruments, rising interest rates and ARM resets).

Credit is about to be less plentiful.