Subprime meltdown offers a crash course

Portfolio managers, investors and their advisers appear to need a reminder every five years or so that risk and return are closely related, that distortions in the market eventually are corrected, that those corrections hurt and that diversification is important.
The collapse of the subprime-mortgage market is providing that reminder this year and reinforcing lessons that should have been instilled, most recently by the collapse of the Internet bubble.
Once again, the unwary have been hit and hurt. Although the extent of the fallout isn’t yet clear, the damage, thankfully, appears to be of a lesser scale than that of 2001.
However, the causes of the implosion appear to be similar: too many investors chasing high returns without sufficient consideration of the risks.
In this case, the subprime-
mortgage market, a legitimate part of the financial scene on a small scale, was pushed to an extreme by the ready availability of liquidity and the apparently never-ending housing boom.
Investors were lured by the high returns financial institutions making subprime mortgages were generating by borrowing short at low rates and lending longer at substantially higher rates.
Those investing in the subprime-mortgage market, either directly or indirectly, failed to ask often enough: What could go wrong? What could cause an increase in borrower defaults?
They failed to consider what would happen if the introductory rates on those mortgages were stepped up to higher long-term rates that borrowers couldn’t afford — or what would happen if the housing market softened and home values dropped.
What happened was that many who had bought homes they couldn’t really afford stopped paying and abandoned the homes. Since they had little equity in the houses, they had little to lose by moving out and allowing them to be foreclosed.
That meant trouble for subprime lenders and also those who owned the stocks of the lenders or other companies servicing those lenders. It also meant trouble for any other company that investors thought might be caught in the fallout.
These include a number of major financial institutions.
Luckily, most mutual fund managers who invested in stocks of companies obviously connected with the subprime-mortgage market kept their exposure relatively low.
Some will have been caught by the damage to the stocks of companies indirectly involved or merely suspected of involvement. Diversification will provide a measure of protection, but the holdings nevertheless will hurt their returns for the year.
The lesson for advisers is that they have to keep an eye on the portfolio holdings of the mutual funds they recommend to their clients. It isn’t sufficient to look over the portfolios before the clients invest.
They must continue to monitor them after the client invests. When they see significant holdings of stocks in overinflated market sectors, they should warn the clients and recommend a prudent course of action.
That is, after all, what they are being paid to do.
Clients also have responsibilities.
They must learn not to be suckers. They must learn to resist the urge to chase hot market sectors or hot funds without doing sufficient homework, without considering the risks and without considering if the market sector might be ready to implode.
In other words, they must learn from the past or they will be doomed to repeat it — and the market will make them pay a price when it corrects.