25 Surprises for 2007

2. Robert E. Rubin returns to his brokerage roots and becomes the CEO and chairman of Salomon Brothers/Smith Barney after Citigroup (C Quote) decides to break up into three separate companies: a domestic money-center bank (Citibank), an investment banking/retail brokerage (Salomon Brothers/Smith Barney) and an international consumer finance company (Citiglobal).

3. Based on misleading government statistics, the housing market appears to stabilize in the first quarter of 2007. For a few months, those forecasting a bottom in residential real estate appear vindicated. Evidence of cracks in subprime credits are ignored, with housing-related equities soaring to new 52-week highs by March 1.

4. However, continued heavy cancellations of home contracts -- which are included in the government releases on homes sold and lead to an erroneous inventory of unsold units for sale -- lead to:

• A dumping of homes on the market in the spring
• A quantum increase in the months of unsold housing inventory
• A dramatic drop in the average home selling price.

Sales of existing and new homes take another sharp leg lower as we enter what I've dubbed "The Great Housing Depression of 2007."

Importantly, the financial intermediaries that source mortgage financing/origination begin to feel the financial brunt of "The Great Mortgage Bubble of 2000-06" after years of creative but nonsensical, low or nondocumented lending behavior.

5. Foreclosures steadily rise over the course of the year to nearly 3 million homes in 2007 vs. about 1.2 million in 2006. Deep cracks in the subprime market spread to other credits in the asset-backed securities market as a lumpy and uneven period of domestic economic growth takes its toll. In a similarly abrupt and dramatic manner, credit spreads fly open and revert back to mean valuations, as previously nonchalant investors are awakened to the reality of credit risk.

6. The magnitude of the credit problems in mortgages takes its toll on the hedge fund industry, which is much more exposed to real estate than generally recognized. A handful of multibillion-dollar, derivative-playing hedge funds bite the dust in the aftermath of the housing debacle. Several California-based industrial banks fail (the West Coast is always at the leading edge of financial creativity and leverage!), and a large brokerage firm, heavily involved in fixed-income market-making and trading, faces material losses, and its debt ratings are downgraded. As the financial contagion spreads, rumors of a $10 billion-plus derivative loss at JPMorgan Chase (JPM Quote) (which ultimately prove to be false) spark the largest one-day percentage drop in its shares in the past 15 years.

7. In a panic, Congress announces a series of hearings on the derivative industry, and the Federal Reserve reduces the fed funds rate by 50 basis points in each of three consecutive meetings. Those efforts are too late to affect the already weakening economy as the long tail of housing begins to affect not only consumer confidence and spending but also other peripheral areas of the economy.

8. Commodity prices begin to collapse even before the mortgage market fiasco, but the onset of the decline is initially ignored by stock market investors. The CRB Index moves below 300. Notably, crude oil falls under $50 in a deflationary scare as interest rate cuts fail to revive the economy. The yield on the 10-year U.S. note falls to below 4% and stays there over the balance of the year.