Deal or No Deal?

One of the problems with subprime loans is that borrowers may just walk away--Searching for Alpha, the monthly index newsletter for April 2007

There tends to be a financial crisis every ten years or so, and subprime loans seem to be the current one. As nearly everyone knows, default rates among many loans that require little or no documentation--so-called "liar loans"--is soaring, leading to numerous write-downs among home builders, lenders, and brokerages.

Optimistic market observers don't think the problem will get much worse. They point out that the issue is confined to a relatively small part of the market. Others fear that, since many of these loans require little or no money down, borrowers have little incentive to work out of a problematic foreclosure scenario. Similar to a game show, where contestants have everything to gain and little to lose, the odds favor more aggressive risk taking. If the game gets out of hand, players can simply walk away.

This latter view could have potentially ominous repercussions, especially if the housing market gets soft. Lower prices for homes could put more folks underwater in their mortgages, which would adversely affect consumer spending and potentially send the economy into a recession.

Although it's too early to tell how the subprime mess will end, there are some definite portfolio changes that should be considered. First, I can't think of many scenarios where owning a large REIT position makes much sense. I'm sure the sector would rally if rates were cut, but so would high grade fixed income, and bonds have a lot less downside currently.

Second, if the mortgage problems persist, credit spreads will eventually widen, causing losses in high yield bonds. Spreads have risen modestly in the last few weeks, but that hasn't stopped junk bonds from putting in a decent first quarter. However, I think current risk-reward scenarios favor more high-grade fixed income going forward.

Finally, I'd consider large cap stocks over more speculative small cap issues. P/E ratios are still reasonable, and the equity of larger companies will likely have muted downside unless the current crisis gets completely out of hand.

The Monthly Index Report for April 2007

Index

Mar-07

QTD

YTD

Description
S&P 500 Index*

1.00%

0.18%

0.18%

Large-cap stocks
DJIA*

0.70%

-0.87%

-0.87%

Large-cap stocks
Nasdaq Comp.*

0.22%

0.26%

0.26%

Large-cap tech stocks
Russell 1000 Growth

0.54%

0.64%

0.64%

Large-cap growth stocks
Russell 1000 Value

1.55%

1.24%

1.24%

Large-cap value stocks
Russell 2000 Growth

0.92%

2.48%

2.48%

Small-cap growth stocks
Russell 2000 Value

1.21%

1.46%

1.46%

Small-cap value stocks
EAFE

2.55%

4.08%

4.08%

Europe, Australasia & Far East Index
Lehman Aggregate 0.00%

1.50%

1.50%

U.S. Government Bonds
Lehman High Yield

0.11%

2.64%

2.64%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

-1.25%

-1.82% -1.82% Managed Futures
3-month Treasury Bill 0.44% 1.31%

1.31%

All returns are estimates as of March 30, 2007. *Return numbers do not include dividends.

** Returns are estimates as of March 29, 2007.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.

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