Deal or No Deal?

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.