Folks, the financial problems many firms encountered in the third quarter relating to structured finance were not a one-time, “Whew, glad that’s over” event.

Let’s review. The housing market is becoming further impaired by the day. Homebuilders have fallen off a cliff faster than most NASDAQ stocks in 2000-2002 (see chart). There remains a massive glut of unsold homes. Subprime borrowing is now a thing of the past. By subprime, I mean all the zero-money-down, ultra-teaser-rate, negative-amortization, jumbo-piggyback, no documentation, “liar loans” and all the rest of the foolishness associated with the mortgage credit bubble of 2002-2005. The housing market is Ballgame Over.

With the absence of this large portion of market participants - meaning those who really cannot afford to buy homes at current prices, but are allowed to do so by ridiculous financing - many housing markets around the country have seen sales slow to a trickle. I have read numerous reports of even relatively quality borrowers (i.e. they actually have stated, stable, verifiable income) being unable to secure mortgages or refinance opportunities. This was unheard of a couple short years ago.

Based on the initial housing and mortgage downturn, many companies have gone south quickly. One great example is Countrywide Financial, which can be described as the perfect case study of the mortgage boom-bust cycle of the past decade (chart). There is a decent chance that this one-time high-flying mortgage behemoth will go bankrupt. The simple fact is that they were way too involved in the credit excesses that spurred the boom of the past five years. Now they are finding out that bad decisions really DO come back to haunt you.

So with housing seizing because prices simply are not supported by fundamentals, mortgage lending seizing because of the preceding foolishness of lending during the boom, as well as unsupported asset values, and the derivative structured finance market being seen for what it really is - a mass of bad loans packaged together to create what look like decent fixed income products, but which are not sound when loans are made during a bubble - the financial economy started to seize.

In stepped the Fed. Now, all of a sudden, everything is “back to normal” and the bulls are back to running (see new Dow all-time nominal high). Complacency has returned to the financial world in a heartbeat.

What people fail to realize is that this is utter denial. Banks and financials cannot write off a couple bad loans and simply call it an end to any issues. This boom played over many years. The bust will be equal and opposite in scope. You simply cannot sweep so many maladjustments and poorly-conceived actions under the rug with one stroke of a Central Bank 50 basis point rate cut.

Before bulls start crowing too loudly about the new nominal Dow high, I caution them that history is not kind to those who try to deny the boom-bust cyclical nature of mass psychology and investment behavior. This article points to the unreal herding behavior on Wall Street. Face it folks, there is no one at the wheel of this thing, although many like to think there is. The market is simply a lot of people looking around at what other people are doing and following suit. In such an environment, mood swings are due to take shape very soon.

Before you think about joining the “What, me worry?” Alfred E. Newman herd, please realize that the panic that entered the heart of many overleveraged hedge fund managers, real estate investors and investment bankers over the past few months was legitimate. The ponzi scheme economy that the US Federal Reserve has encouraged over the past 25 years, one which Wall Street has been happy to provide, is due for significant adjustment in the near future. Ride the wave of denial at your own risk…

“The ultimate effect of deflation is to reduce the supply of money and credit. Your goal is to make sure that it doesnt reduce the supply of your money and credit.” - Elliott Wave International

Filed under: Social Mood, Economics