I’m not normally the doom and gloom type but what I’ve been reading about subprime mortgage debt has me a bit concerned… I don’t know what will happen but one possibility is laid out below.
There are approximately six million subprime mortgages in the USA. The average home price is $190,000. This comes out to $1.14 Trillion (with a “T”) in subprime debt. Let’s round that down to $1 Trillion both for simplicity and the assumption that many of these loans are on lower-end houses. These loans are packaged up, along with non-subprime loans into Collateralized Debt Obligations (CDOs). The CDOs are then sold to institutional investors such as pension funds and hedge funds.
Based on the numbers above, a 1% drop in home values would then equate to a $10 Billion loss of value in the underlying assets of these CDOs. While this might seem bad enough it’s actually far worse. You see, the funds buying these CDOs use them as collateral to borrow more money, which is then invested in more CDOs or other assets such as stocks and other bond assets. The total leverage being used is unknown but is in the neighborhood of 10 to 25 times the value of the underlying assets. So our $1 Trillion in CDOs equates to $10-25 Trillion in total assets whose prices have been supported by the underlying mortgages.
So going back to our 1% drop in housing values… The $10B loss is now multiplied to $100-250 Billion. If funds are forced to liquidate assets to cover these losses it could put further downward pressure on CDOs which might turn into a feedback loop. At a minimum it would put severe downward pressure on all of the asset classes which have been pushed upward by the use of these financial instruments, including stocks, bonds and real estate (the number of foreclosed homes has increased dramatically nationwide and has been putting severe downward pressure on home prices.) As bond prices are depressed, interest rates will rise across the board which will further exacerbate the problem as more Adjustable Rate Mortgages (ARMs) adjust upward.
As asset prices decline and interest rates rise the economy, already growing a very slow pace (and some say in a recession already) will slow more. This will force the Federal Reserve to drop it’s interest rates and inject cash into the economy in an attempt to prevent a complete meltdown. At this time, the rest of the world is in the process of tightening their monetary policy, raising interest rates. So the Fed’s injection of liquidity into the US will have the effect of further depressing the dollar (already at multiyear lows against most other currencies). This will drive up prices of imports (take a look at how much of what you buy is from China and other countries) and inflate prices in general. This condition is known as “stagflation” which is the combination of a stagnant (or shrinking) economy and high inflation and rising unemployment.
The last time the US experienced stagflation was in the 1970s, mainly during the Carter administration. The solution at the time by Fed Chairman Paul Volcker was to sharply increase interest rates to reduce the money supply. (I remember my parents getting paid 18% interest on bank CDs at that time.) But wait…in our scenario above the Fed was reducing rates to prop up asset prices and the economy in general. So what can we do in this situation? I hope we don’t find out but to me it looks like we’d have to make a choice between a long period of high inflation and the further collapse of the US Dollar against other currencies or a severe monetary contraction, possibly leading to a situation similar to the Great Depression.
What will happen is anybody’s guess. The world economy is a lot more integrated than it was in the 1930’s. Perhaps the explosive growth in emerging economies will help absorb the shock somewhat. Perhaps these fears are all overblown. Time will tell.
Preparing for such events is a wise thing to do whether or not they happen. Live below your means, have an emergency fund and be prepared to rebalance your portfolio and invest more if we’re given an opportunity to do so at bargain basement prices.
My next concern is where to stash our retirement and other assets. To date I’ve attempted to be a bit of a market timer. I’ve grown to realize that this is a mistake and that the odds of correctly timing the markets are abysmally slim. That being said we are about 30% in cash and 30% bonds at the moment. My plan is to design our ultimate portfolio over the course of the next few weeks or months and start implementing that plan. Rather than throwing all of the money we have in cash/bonds back into equities however we’ll likely do so over the course of a couple of years in order to cost average (or actually value average) our way back into the market. I don’t know what our ultimate portfolio will be but it will be mostly stocks with a healthy does of International and Emerging Market equities, a smaller amount of bonds and probably some precious metals/commodities.