The Fed's surprise rate cut may help calm the markets. But in the meantime, sell risky plays and move into high-quality companies. By Fred W. Frailey, Editor August 17, 2007 Financial bubbles never unwind in an orderly way, and now we contend with two -- a housing bubble and a credit bubble, both ending badly. Today the question is not whether the stock market and the economy will be hurt, but how much. One bad sign: Economist Ed Yardeni, known for his optimistic outlook, in mid August doubled (to 30%) his odds of a recession in the next six to 12 months. Odds of the stock market's setting new highs again this year are slender indeed. RELATED LINKS Wall Street Manages a Late Turnaround Investors Guide to Volatile Markets Most menacing is the collapse of the $1.1 trillion market for mortgages that were issued in recent years to poor-risk homebuyers. These subprime loans were packaged and sold with investment-grade ratings, sometimes even AAA, to hedge funds, banks, pension funds (and a few mutual funds) both here and abroad. Then in July, with delinquencies rising, the ratings agencies relabeled a slew of these securities as junk, causing them to be marked down by as much as two thirds and setting off a financial panic that threatened to cut off credit to even the best risks. Remarks Yardeni: "The mortgage market is shutting down." Advertisement Evidence of that became starkly apparent on August 16, when the nation's largest mortgage lender, Countrywide Financial (symbol CFC), drew down its entire $11.5 billion line of credit just to stay in business and avert bankruptcy. The day before, Countrywide had lost access to the market for commercial paper, its customary source of short-term funding. Countrywide says it now has enough cash to survive this financial panic. Yet it will all but cease issuing anything but conventional loans, which are the easiest to sell in secondary markets. Bear in mind that Countrywide wasn't a big player in subprime loans. But so great is the aversion to any mortgage debt on the credit markets right now that it's hard to even price some mortgage securities, particularly those linked to homeowners with spotty credit histories. The worst of it is, nobody knows the full dimensions of the subprime debacle. So it's impossible to do more than guess at how this panic will play out. J. Kyle Bass, managing partner of Hayman Capital Partners, was told on a visit to California's Central Valley that up to 90% of the subprime loans in that region involved fraud. Most subprime paper is held by secretive banks and hedge funds. Every time word trickles out that an over-leveraged hedge fund holding subprime paper has imploded, the stock market shudders. Advertisement The subprime debacle crimped leveraged buyouts, which had been a pillar holding up stock prices. Merrill Lynch economist David Rosenberg observes that all public and private U.S. debt now amounts to 340% of our annual economic output -- a record-breaking ratio fed by years of easy-to-get money. Big contributors to the debt bubble were leveraged buyout, or private equity, firms that borrowed money at low rates to take public companies private. Now the credit window has closed. Deal-making has ground to a halt. The financial panic will undoubtedly affect economic growth. Whether growth merely slows or the U.S. economy falls into a recession could depend upon events of the next few weeks. Treasury Secretary Henry Paulson told the Wall Street Journal that turmoil in the financial markets would stunt growth in the economy but that a recession would be averted. Of course, that's what the nation's CFO is supposed to say when times get tough. Any positive news on the housing front would help. But none appears to be forthcoming. Construction of new homes during July fell to the lowest level since 1991 -- 21% off the pace of a year ago. Applications for building permits, considered a leading indicator of future construction, fell during July, too. This followed news that sales of existing homes fell in 41 states during the April-June quarter. Advertisement Something else already has helped: In a surprise move August 17, the Federal Reserve cut the discount rate on loans to banks half a percentage point. That helped the Dow close up 233 points August 17, a 1.8% climb. Other stock indexes were up sharply on the news, as well. But the risk is that bad news will just keep oozing out, causing still more financial damage and sapping public confidence -- in short, the perfect precursor to a recession. It would be nice to say, stay the course. But the stock market's turbulence makes that a risky option for investors. You would be wise to seek safety in the storm. Sell speculative stocks, including those in emerging markets, and keep selling until your pulse rate is normal on days the Dow is down 200 points or more. There's a lot to be said for cold, hard cash today. Once some uncertainty is lifted, use the cash to pick up hammered shares of high-quality companies. Fred Frailey is editor of Kiplinger's Personal Finance magazine.