Updated: May 3, 2013 12:14PM
Subprime mortgages are like pollution. A little drop of black ink in the pool will spread throughout the water, and you'll never notice. But pour a bottle of ink into the water, and everything turns gray.
That's what's happened with subprime mortgages, as financial institutions around the world discover that their assets are polluted with mortgages made to borrowers who are now in default.Planning for bad loans
Lenders plan for a relatively few loans to go sour. That's part of their standard risk calculation. The money they make on the good loans is designed to far offset the losses on the bad.
At least that's the way it worked in the "good old days," when bank officers looked the borrowers in the eye, judged the risk, and kept close watch on the payments.
All that changed when mortgages became "securitized" - put into pies that were sliced into pieces, and sold off to financial institutions that were looking for a stream of income. These slices or "tranches" even received ratings from the bond rating companies on the basis that "pooled risk" minimized the potential for loss.
In effect, the idea was that spreading the risk would lessen the risk of pollution. But just like the bottle of ink, the questionable loans grew inside the mortgage securities, and spilled into the waters of the credit markets.
We're back to basics now: Spreading the risk does not eliminate it.
Given the global nature and depth of the markets, the recognition of spilled ink is not expected to destroy these huge markets. But it will color the balance sheets and earnings statements of a broad array of institutions, ranging from domestic mortgage brokers already in bankruptcy to large U.S. financial institutions and, now, global banks.
The world's central banks -- including Japan, Canada and our Federal Reserve -- are attempting to dilute the pollution by pumping more credit into the system. The central bankers hope to wash away the stain of those bad loans, which are rising to the surface of credit portfolios like dead fish in a polluted pond.
The immediate impact is to alleviate the crisis. Interest rates on the safest securities, U.S. Treasury bonds, notes and bills, are already falling as scared investors (even the big ones) rush to the safest instruments around.
One day, all this newly created credit will have the opposite impact, and will raise fears of inflation, and thus push U.S. interest rates higher. But that's for later. Right now, it's a rush to the security of the highest quality. And that's defined as short-term Treasury bills and notes.
Of course, regular readers of this column already have their quotient of "chicken money." That's Treasury bills (bought online through www.TreasuryDirect.gov) as well as short-term, FDIC-insured bank CDs and money market deposit accounts.
Yes, these chicken money investments offer lower yields, but real peace of mind. Suddenly we're back to that old bit of Savage Truth: "I'm not so concerned about the return on my money, as I am about the return of my money."Time to sell?
Now, to address that final, dual question in your mind: "Is this the end of the bull market, and is it too late to sell?"
Having received more than a few e-mails asking that question, it's only fair to give an honest response: "I don't know." And no one else does either. So let's go back to that other Savage Truth: "Sell down to the sleeping point."
Over the long run -- at least 20 years -- history says you'll come out ahead with a well-diversified portfolio of stocks. But we each have a different time horizon, and a different risk tolerance. Having a portion of your investments in chicken money gives you the courage and discipline to ride out the volatility of the stock market.
Now you have the challenge of figuring out just how much safety you need to sleep at night.
One final warning: The best decisions are made calmly -- and never out of emotion. And that's The Savage Truth.
Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.