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It has become the stock market's kryptonite. It seems every time a breathless CNBC anchor even whispers the word "subprime," the Dow falls 100 points.
Forget, for a moment, about whether the subprime fear is justified (I'll get to that). For now, focus on these four rules when trying to avoid losing money in these subprime-obsessed times.
- Don't let the alarmists frighten you out of stocks that have no direct exposure to the subprime mortgage problem. It's too small to bring down the whole economy.
- Use any subprime-inspired weakness to buy cyclical stocks on the cheap. This group, which features stocks that do best when the economy is strong, includes Dow Chemical (DOW, news, msgs) and Alcoa (AA, news, msgs) and tech stocks like Intel (INTC, news, msgs). I think the economy's going to stay strong.
- Steer clear of anything housing-related -- the damage isn't over yet. Be especially careful with home builders that have the most exposure to subprime borrowers, like Standard Pacific (SPF, news, msgs) and KB Home (KBH, news, msgs). I'd also take a pass on retailers exposed to the home-building sector like Home Depot (HD, news, msgs) and Lowe's (LOW, news, msgs).
- Don't try to bottom-fish subprime lenders with big exposure to the problem, such as Accredited Home Lenders Holding (LEND, news, msgs) and Fremont General (FMT, news, msgs). There may be more surprises ahead.
The only thing we have to fear
Now, to answer the question about whether the fear is justified, let's take a look at what's causing the immediate pain.As home prices moved higher in the past few years, lenders rolled out more exotic loans to make houses more affordable to buyers with poor credit scores or too little income to get a standard mortgage. Lenders cranked out loans with adjustable rates and low teaser rates, or "interest only" loans with minimal down payments. Lending standards were also relaxed. For example, a lot of borrowers got loans with less proof of income than homebuyers normally need -- known informally as "liar's loans" because borrowers are presumed to fib about their incomes.
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"In the past nine months anybody with a pulse (who) was interested in buying a home was able to get financing," says Ivy Zelman, an analyst who follows the housing sector at Credit Suisse. The result: Last year about 20% of loans were subprime. Another 20% were in a category called "alt-a," or mortgages originated with relaxed lending standards. Lenders were hoping that home prices would continue rising so much that borrowers could get some breathing room by refinancing.
They've had no such luck. Now, alarmists worry that a subprime mortgage disaster will ruin economic growth in two ways:
- So many subprime borrowers will default that a torrent of homes will hit the market, pushing down prices and scaring consumers.
- The subprime borrowers who survive will see their introductory rates "reset" and move up so sharply that it will kill the family budget. Zelman thinks monthly payments on these loans could go up 20% to 40% this year.
The net result: Consumer spending will plummet, and that will kill economic growth. "I expect it to get much worse," predicts investment guru Jim Rogers.
Sub-problematic
But here's why the subprime disaster scenario won't play out: The problem is too small to overwhelm all the forces that support continued economic growth -- which we'll get to in a minute."The vast majority of borrowers will be fine," predicts Christopher Cagan of First American CoreLogic, a research group. He thinks that 13% of the 8.4 million adjustable-rate mortgages originated in 2004-2006 will ultimately wind up in foreclosure. That will hurt the lenders and investors who hold those loans -- to the tune of $113 billion.
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Subprime effectsWas the past month's subprime slide notable? Some say it's just the beginning of a mortgage meltdown.
But it's not enough to damage the economy, and it won't spark a wave of selling that will bring down home prices. "We don't see a significant problem in terms of home prices collapsing," predicts David Goerz, the chief investment officer of HighMark Capital Management.
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