The Worst Is Yet to Come

It took months of rising defaults, bankruptcy filings, and warnings from experts, but it looks as though the market finally gets it: Subprime mortgage loans are risky. In the past month, most companies tied to the lending or housing industries have been pummeled. Luminent Mortgage Capital (NYSE: LUM  ) fell nearly 80% after several lenders alleged that the company failed to meet margin calls. Meanwhile, shares of Thornburg Mortgage (NYSE: TMA  ) fell off a cliff as a result of bankruptcy concerns before the jumbo lender sold $500 million of high-yield preferred stock.

But have investors truly learned their lesson? It's true that the S&P 500 is down 5% from its mid-July peaks, but rumors of reduced interest rates and a federal subprime bailout have much of the market believing that the dangers of risky mortgage lending are behind us.

You call that a meltdown?
The market's optimism is encouraging, 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. A 2006 study by the Mortgage Asset Research Institute found that 60% of stated income borrowers had "exaggerated" their income by more than 50%.

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 levels.

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-riskier "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 estimate 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 and homebuilders such as DR Horton (NYSE: DHI  )  will probably continue to suffer, and the worst companies in these industries may fail altogether. 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 Home Depot (NYSE: HD  ) and consumer-discretionary concerns such as Tiffany (NYSE: TIF  ) . In fact, you'll probably want to avoid all luxury-good manufacturers and any retailer with heavy consumer credit exposure.

Gimme shelter
However, certain types of investments 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 purchase Procter & Gamble's (NYSE: PG  ) deodorant, detergent, and diapers. Similarly, Pfizer's (NYSE: PFE  ) prescription medications will continue to be best-sellers. What's more, these companies sell their products in countries all over the world 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 of our top dividend-paying stocks with your 30-day free trial. There is no obligation to subscribe.

This article was first published July 26, 2007. It has been updated. 

Although Fool contributor 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. Pfizer and Home Depot are Inside Value recommendations. The Motley Fool's disclosure policy will never default.

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