Subprime Overview

As you likely now know, there was a shock in the stock market last week. Shocks have occurred before. The Fed has thrown money at it and things settled down. But a lot of people are concerned that this problem is different. Here's why:

This from John Mauldin's newsletter (free: subscribe here)

And one last difference between 1998 and today. Back then, the problems in the markets became known and were priced into the markets in relatively short order. It is going to be several years before we know the extent of the subprime losses. Remember the table that I used last week which showed the bulk of subprime mortgage interest rate resets was not until the first half of 2008. [This table shown in billions, the amount of adjustable loans to reset and when they begin to reset]:

It is going to take years for the markets to know what the losses on the subprime will actually be.

And it is not as if it should be a total surprise. Any investor can go to their Bloomberg and pull up a listing of subprime Residential Mortgage Backed Securities. There are 2,512 of them. If you sort by the ones with the most loans over 60 days past due, you find that the average RMBS has 12.39% of their mortgages over 60 days, and 2.39% have already been repossessed (REO in the next table), with almost 5% in foreclosure.

...

"Let me reinforce my point with a basic but very appropriate analogy. In Japan, there is a distinctive puffer fish called the Fugu. It is served in special sushi restaurants by master chefs. Fugu tingles in your mouth when you eat it. It is supposed to be an exotic aphrodisiac in Japan, where diners spend hundreds of dollars a serving to eat it. The problem is that eating Fugu can kill you. There is an old saying in Japan, 'I want to eat Fugu, but I don't want to die.' People have been known to literally drop dead in sushi bars from cardiac arrest and pulmonary failure if the Fugu they ate wasn't prepared correctly. You have to be a specially trained and licensed Fugu chef to prepare and serve it. Personally, I would want to see the stats of the chef before eating Fugu...just a simple 'number of customers killed' would work for me.

"Now imagine a family in your town called the Griswolds. (You may remember them from the National Lampoon 'Vacation' films.) Suppose for their next trip, the Griswolds decide to travel to Japan and pursue some gastronomical thrills and eat the infamous Fugu. So they do some cursory research, march into a Tokyo Fugu restaurant, plunk down $1,000 and order a huge plate of Fugu. And die on the spot.

"The next morning as you sit at your breakfast table sipping coffee, you read the following headline:

"LOCAL FAMILY DIES EATING EXOTIC POISONOUS FISH IN TOKYO"

"You think to yourself, no problem... you continue sipping coffee... and maybe mutter... 'They should have known better.'

"Now imagine instead that you read the following headline:

"LOCAL FAMILY DIES IN FISH RESTAURANT"

"Your reaction may be very different. You are likely going to cancel your reservation at the local sushi bar until you hear more. What if all fish are tainted? Or is it just that restaurant? Or is it a specific type of fish? You'll have lots of questions, and you might assume, until you know more, that no fish are worth eating.

Mauldin is exactly correct. It's going to take months to have any kind of sense of just how big the mortgage default situation is. It's going to likely take years to know the impact of defaults on consumers, housing prices, and the value of underlying bonds that support mortgages. Until then, the headlines coming out are going to be imprecise and the information sketchy. Markets do not like sketchy.

As I've said before, only a fool would predict a collapse. But, also, only a fool would predict that a collapse can't happen. The fact is, no one knows, which is exactly the problem. So get ready for a wild ride if you have any investments.