How Investors Should View the Subprime Mortgage Troubles

You expect stocks to suffer if interest rates soar or inflation spins out of control. That's not happening, but for much of 2005 and 2006, escalating oil prices spooked the financial markets until wiser heads figured out that America's efficient economy isn’t defined by prices at gas pumps. Inflation fears eased, and you and your portfolio reaped the benefits.

Now, after almost a year of bull-market bliss, fear is back. Stocks lost 5% over a couple of weeks, all of it in two bad days. The fuss is over something that until recently you probably had never heard of: "subprime" mortgages and, more particularly, a growing number of defaults on homeowners who had taken out subprime mortgages. Freddie Mac describes these as loans that charge high -- typically adjustable -- interest rates, a high number of points and fees, and high prepayment penalties. Lenders extend them to people who lack cash for a down payment or who have spotty job and credit histories. These loans are difficult or impossible to refinance. Yet the interest rates adjust more quickly and more sharply than do other kinds of ARMs.

Subprime loans are a small part of the total mortgage pool, but they've gone from fewer than 10% of new-home loans to about 20% in five years. The link between them and the stock market is that subprime lenders depend on the capital markets for money to make these loans and on investment bankers to buy them, assemble them into high-yielding mortgage securities and sell them to investors. Since subprime loans don't meet the standards for, say, inclusion in government-guaranteed Ginnie Mae mortgage-backed securities, investors who buy the riskiest mortgage packages feel the pain when borrowers miss payments. The most recent data show that 13.3% of all subprime loans are more than 90 days delinquent. That's up from 11.6% a year ago and is five times the rate for the most-creditworthy mortgages. Several issuers of subprime loans are now closing up shop, and others are trying to sell subsidiaries that specialize in the loans.

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On March 14, the stock prices of several of these lenders soared -- after falling sharply for weeks -- on optimism that they will be sold and that the subprime business will be reformed. But tighter credit standards make it harder for as many people to stretch to buy homes, particularly first-time buyers. Merrill Lynch economist David Rosenberg thinks that as a result, U.S. housing values will fall by 10% this year. If that happens, he says, growth will slow so much that the economy will be in near-recession. More optimistic economists still think the U.S. can grow 3% for 2007.

The impact of housing on the overall economy is the subject of an intense debate between the glass-is-half-full and the glass-is-half-empty crowds. But let’s get back to the stock market, which reacts to news much more quickly than does the economy. Any shock to the financial system stirs the bears, so subprime troubles probably really do explain why U.S. stocks lost 2% on March 13. But that doesn’t mean this massive selloff, which took down 93 stocks for every seven that gained, was logical. It's hard to see how the subprime problems will contaminate large swaths of the economy. Other segments of real estate, from farmland to office buildings, are healthy. The total percentage of all credit at America's 100 largest banks that is delinquent is 0.45%, according to fresh figures from the Federal Reserve Board. That is not only amazingly low, but it is lower than at any time since the spring of 1995. And while it’s unfortunate that one of out seven of these up-by-the-bootstraps homeowners is three months behind on payments, the proportion isn't out of whack with historical trends. Compared with prime loans, the delinquency rate for subprime mortgages was also five times higher in 2002. The rest of the credit-based economy didn’t sink then. There’s no reason why it should now and torpedo the stock market.

Fear of contagion

Of course, there are good reasons to fret if you focus on some of the headlines, which have been screaming about housing falling into a black hole and dragging your stocks and mutual funds to the bottom with it. Such fear-mongering is unwarranted -- Moody’s called the March 13 plunge "gratuitous" -- but stockholders do have some reasons to be concerned.

One is that the fast growth of the subprime business has attracted important companies that are not traditional bankers. Among these are General Electric, General Motors, Goldman Sachs and H&R Block. These companies or, more specifically, their subsidiaries, either earn fees by making the loans or collect a spread by reselling them to other investors. If subprime lending slows sharply or delinquencies get worse, this earnings stream will shrink.

That would not be good for the share prices of anyone with a stake in the business. For example, Goldman Sachs (symbol GS) reported fine earnings on March 13, with excellent results in every one if its businesses except mortgage trading, which is minor compared with its merger and acquisition and stock-trading arms. But the subprime cloud nicked Goldman shares anyway. The stock, which closed at $200.15 on March 14, has fallen 10% since February 20. H&R Block (HRB) is trying to sell its subprime mortgage company, Option One, but this comes after Block had to add $93 million to reserves last year because defaults reduced the value of the mortgages. After Block wiped $15 million from earnings in March, its stock, which nearly reached $25 in early February, fell almost to $18 before closing on March 14 at $20.14. Block says it has tightened its lending standards, but that means anyone who buys the mortgage business will pay less for it than it might have before the subprime crisis materialized because the unit will make fewer loans, and those that it does make are likely to be less lucrative than the loans it could make to less-creditworthy customers.

Investors in homebuilding stocks have particular reason to be concerned. If you thought builders' shares were set to bloom with the arrival of spring, forget it. Because fewer first-time buyers will be able to rely on creative mortgages to get their keys, builders will have to cut deals or sell fewer houses. Apartment rents may rise faster than before, which normally would spur renters to strain to buy. But if tenants can't qualify for mortgages, home resales will also slow. Some 9% fewer homes were sold in 2006 than in 2005. A similar decline is in the offing for '07. Even higher-end builders whose customers don't need subprime mortgages will see fewer customers.

A third problem is that all of these housing-related problems are occurring just as other issues challenge the stock market. First-quarter earnings season is getting closer and, as usual, there’s trepidation about which companies will meet expectations and which won’t. The Federal Reserve Board isn't inclined to help investors by cutting short-term interest rates soon, although pessimistic economic forecasters think lower rates are essential to protect against a recession this year or next. But as long as credit is freely available for solvent consumers and businesses and as currency for mergers, the Fed can safely leave rates alone to concentrate on battling inflation. Profits and dividends will have to carry the ball for stocks.

Courses of action

Fortunately, investors have plenty of other opportunities in areas that are far removed from housing and mortgages. If you look at the red ink smears on March 13, you'll see that many industrial heavyweights, such as 3M, Boeing and GE (despite its subprime exposure) didn't get hit much. On the 14th, the Dow Jones industrials regained 57 points, or one-quarter of the previous day’s losses, but advancing stocks outnumbered decliners. Shares of many subprime lenders rallied in response to upgrades by a few brave analysts and in anticipation, perhaps, of buyouts.

The best investment ideas for the next few months remain the customary, sensible ones: Stick with your favorite diversified mutual funds. In individual stocks, the safest bets are large, cash-rich growth-oriented companies that pay good dividends or are repurchasing their own shares and do business all over the world, such as American Express, Boeing, 3M, ExxonMobil, IBM, Johnson Controls, and many others. You can consider most any stock among Standard & Poor’s Dividend Aristocrats. These are companies that have raised dividends for 25 years in a row, and you can own them through the exchange-traded SPDR S&P Dividend fund (SDY). The ETF yields nearly 4%, and the costs to own the fund are minimal.