The Worst Is Yet to Come

Remember the subprime meltdown last winter? Low-credit borrowers defaulted on their home loan payments in increasing numbers when their adjustable-rate mortgage interest rates reset. Shares of major subprime lenders like Countrywide Financial (NYSE: CFC  ) plummeted, while the most egregious offenders filed for bankruptcy.

Investors were pretty panicked -- for about a week. The market fell 5%, but quickly rebounded. Within a month, those losses were erased, and the major indexes were setting all-time highs by summer.

You call that a meltdown?
The market's resurgence was impressive, but let's not pat ourselves on the back just yet. The subprime episode wasn't a meltdown, a crisis, or a disaster. It was a warning, and we failed to heed it. The real meltdown is coming ... and its name is Alt-A.

No one knows for sure when the Alt-A implosion will happen, or how much damage it will ultimately cause. But the experts do agree on one thing: The Alt-A fallout will make the subprime situation seem like a minor chimney fire.

I have a few suggestions on how you can protect your portfolio, but first, let's get to know the enemy.

Pants on fire
If you aren't familiar with Alt-A mortgages, perhaps you know them by another name: These products also go by the charming moniker "Liar Loans," because many Alt-A borrowers overstate their income and/or assets and provide little or no documentation to secure their mortgages. Historically, lenders reserved Alt-A mortgages for borrowers with blemished but not irreparable credit. Accordingly, these loans carry an interest rate somewhere between prime and subprime.

However, in recent years, the Alt-A segment has evolved. Now it reflects the type of mortgage product rather than the credit quality of the borrower. Mortgage lenders have devised ever more risky "exotic" mortgage products, most of which fall under the Alt-A label. Interest-only loans were a particularly devious innovation. Worse still are "negative amortization" loans, where the monthly mortgage payment is based on a below-market interest rate for an initial period (think of a minimum payment on a credit card).

These exotic mortgage products aren't dangerous in and of themselves. The problem occurs when a borrower uses these products' lower initial monthly payments to qualify for a home that he or she otherwise could not afford. According to a recent Credit Suisse report, surging home prices and record-low interest rates over the past five years tempted many borrowers: In 2001, interest-only and negative amortization loans comprised 1% of total mortgage purchase originations. By 2005, that figure was 29%.

Prediction: pain
The recent influx of exotic mortgage products wouldn't be troublesome as long as mortgage lenders maintained disciplined underwriting standards (they didn't) and home prices continued to rise (they haven't). When those artificially low initial rates reset, the damage will likely be severe. But because these new mortgage products have never been tested in a stress scenario, it's difficult to quantify the potential impact.

Consider the dire prediction of Lou Ranieri, widely considered the father of the mortgage-backed securities industry: The subprime meltdown "is the leading edge of the storm," he said last March. "If you think this is bad, imagine what it's going to be like in the middle of the crisis." Between subprime and Alt-A, Ranieri estimates that more than $100 billion of home loans are likely to default.

Ranieri's forecast may turn out to be accurate, or it could be exaggerated. Either way, this much is clear: Many Alt-A borrowers will struggle to make their monthly mortgage payments. Some will lose their homes.

But wait, there's more

Alt-A lenders such as IndyMac Bancorp (NYSE: IMB  ) and homebuilders such as KB Home (NYSE: KBH  ) should continue to suffer, and the worst companies in these industries may fail. But even if most homeowners manage to make their mortgage payments, they probably won't have any disposable income left over.

That means we can expect soft sales at home improvement retailers such as Lowe's (NYSE: LOW  ) and consumer discretionary concerns such as Harley-Davidson (NYSE: HOG  ) . In fact, you'll probably want to avoid all luxury-good manufacturers and any retailer with heavy consumer credit exposure.

Gimme shelter
However, there are certain types of investments that should weather the Alt-A storm just fine -- or at least better than most.

Dividend-paying stocks aren't the sexiest securities in a bull market, but when the going gets rough, these high yielders are tough enough to keep going. Look for established companies with strong balance sheets, a history of dividend increases, and a portfolio of products that will always be in demand. No matter the state of the economy, consumers will always turn to Kimberly-Clark (NYSE: KMB  ) for tissues, towels, and toilet paper. Similarly, Johnson & Johnson's (NYSE: JNJ  ) consumer health-care products will continue to be best-sellers. What's more, these companies sell their products in more than 150 countries and have a history of raising payouts to shareholders.

Our Motley Fool Income Investor scorecard is stacked with stocks that should really shine if the market takes a turn for the worse. Click here to view all our top dividend-paying stocks with your 30-day free trial. There is no obligation to subscribe.

Although Rich Greifner is not a homeowner, he still feels the need to overstate his income. Rich does not own shares in any of the companies mentioned in this article. Johnson & Johnson is an Income Investor recommendation. The Motley Fool's disclosure policy will never default.

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