DOWN DOWS | Cognitive Dissonance 2

July 11, 2008–On Nov. 8 last year, in DOWN DOWS | Cognitive Dissonance  and then on  Nov. 8 in  Huffington Post, I noted that Bob Janjuah of the Royal Bank of Scotland had raised the upper end of his estimate of cumulative subprime write downs. His estimate was $500 billion at a time when losses of just $50 billion were acknowledged by institutions. Now Janjuah looks like an optimist:

1. Bridgewater Associates, the world's second-largest hedge fund, has estimated likely asset writedowns at $1.6 trillion, i.e., a 6 percent overvaluation of $26.6 trillion of risky credit-based U.S. assets (mortgages, credit receivables and credit-card receivables). Some bankruptcies are predicted.

2. David Rosenberg, Merrill's Chief North American Economist, argues in a July slide show that more bad news is in store:
- A recession? We're in it. Just a question of how bad it gets and for how long.
- Asset values? Not yet priced low enough to reflect the recession.
- Housing prices? Could fall another 20 percent.
He therefore believes that while stagflation is the problem today, tomorrow it will be deflation and Fed policy must therefore remain accommodative.

Recent declines in the Dow are closing the disconnect I noted on Nov. 8 between the debt and equity markets. But the months ahead will be challenging for private investors and government officials at all levels.

BUBBLE | Cognitive Dissonance - Equity- vs. Fixed-Income Markets

My point on October 19 about the relevance of cognitive dissonance – which John Tierney has since written about in the NY Times in a non-Wall Street context – continues to apply through two more seriously down Dows, the second of which was the 361-point decline yesterday.

The cognitive dissonance is between signals that securitized subprime losses and other bad news are fully written off/discounted and other signals suggesting that they are not. Or, as a Wall Street trader put it to me at noontime yesterday as we were listening to Fed Governor Kevin Warsh: "The equity markets have been saying one thing and the fixed-income markets another. They can't both be right." Traders make their living by surgically eliminating their preconceptions based on new truth and making swift moves in advance of other investors.

The fixed-income markets were at their most bearish yesterday since August, while equity investors have mostly been hanging on in the hope that the latest Dow drop is the last. Professionals are more wary of "catching a falling knife" by believing that what looks like the end of the bad news really is. I remember that in the summer of 2000, after the disastrous March downfall of the dotcoms, someone was attempting to sell shares in a bottom-fishing hedge fund that would pick up dotcom bargains. Well, the dotcom basement had a sub-basement and even a level B and C below that, as we found out in November 2000 if not before.

The fast-growing Royal Bank of Scotland, fifth-largest bank in the world, takes a surprisingly dim view of how much more in the way of losses remains to be declared. Its chief credit analyst, Bob Janjuah, estimates subprime losses and new accounting requirements (FASB 157, effective Nov. 15, which make it hard to mark Level 3 assets to "make-believe") will bring cumulative writedowns in the $250-$500 billion range. Up till now we have seen at most $50 billion acknowledged. So either RBS exaggerates, or the capital markets have further significant adjustments to make.