The "Moral Hazard" Within Subprime Lending

Worried about the economy and how the effects of the subprime credit crunch might affect your hard-earned investment portfolio in coming months? You are not alone, fellow Foolish investor. The subprime mess appears to be spreading tentacles like an octopus: first the housing market, then retail sales, followed by lending institutions, now moving to overseas markets. Where does it all end?

While no one has the answer to that question, it's becoming clear (to me at least) that this debacle hasn't yet run its course, and there will be additional shoes dropping in months to come. Yesterday, even Alan Greenspan admitted that while he understood adjustable-rate mortgages (ARMs) could leave subprime borrowers vulnerable, he "had no notion of how significant they had become until very late." If Greenspan was late in recognizing the risk, what does that say for the prospects for millions of individual investors?

Don't count on a bailout
One thing we should definitely not be counting on is a bailout by the Federal Reserve. Fed Chairman Ben Bernanke made it clear a few weeks ago that while the central bank would "act as needed" to limit fallout, it would not bail out investors and lenders.

What lies behind this policy is a concept known as "moral hazard." In short, moral hazard arises when a party believes it will not have to face the full consequences of its actions, giving it an incentive to act in ways that may be inappropriate.

The many faces of moral hazard
Moral hazard can rear its ugly head all over the place. Recent history is full of examples, from Third World countries borrowing money and then defaulting on the debt, to the savings-and-loan crisis of the 1980s. In the subprime world we are seeing moral hazard effects relating to both borrowers and lenders. Borrowers take on more credit than they can handle, believing it's not their money at risk, and bankruptcy is a reasonable out. Lenders offer credit to high-risk customers, with the intent of packaging the loans and selling the paper to other lenders who will bear the risk of default.

Moral hazard is not limited to the world of finance. Insurance companies deal with the problem constantly. Once an insured person knows he's covered, will he act as diligently to prevent the event -- fire, theft, you name it -- from occurring? Insurance companies know he won't, and price their products to cover this additional risk.

Is there a safe haven?
Outside of Treasuries and money market funds, I don't know of any completely safe haven from the storm we're experiencing. But if you intend to keep a portion of your portfolio in stocks, I have a strategy to suggest.

The strategy involves a market segment of defensive stocks that have minimal exposure to credit risk. As such, they are not likely to be greatly affected by adverse conditions in credit markets.

These companies all have the following characteristics:

  • They make products everyone buys and no one can do without.
  • They have substantial positive free cash flow so they don't need to borrow money.
  • They don't sell to consumers on credit.

Sound good? They are the consumer product giants. Here are five you may wish to consider:

Company / Ticker

Revenues

P/E

FCF

Procter & Gamble (NYSE:PG)

 $ 76.5

 17.3

 $ 11.0

Unilever (NYSE:UL)

 $ 52.3

 15.6

 $ 4.6

Kraft Foods (NYSE:KFT)

 $ 34.4

 17.5

 $ 2.6

Johnson & Johnson (NYSE:JNJ)

 $ 53.3

 14.4

 $ 11.6

Pepsico (NYSE:PEP)

 $ 35.1

 18.7

 $ 4.0

Revenues and FCF (free cash flow) are most recent fiscal year, in billions.
P/E (price-earnings ratio) is forward 12 months.
Source: Yahoo! Finance.

I'm sure these aren't the most exciting growth stocks you've seen in a while, but that's the whole point. These are companies with long histories of making stuff millions of people consume every day. They have excellent brands, strong management, and they really know how to rake in the cash.

Speaking of cash, what do these companies do with the piles of green they accumulate? All of them pay out dividends and buy back stock, so you're a winner no matter which side of that debate you fall on.

Consumer product companies aren't for everyone, and I certainly wouldn't recommend you jump into them with both feet tomorrow. But every good portfolio should include investments that span the risk spectrum. How much you invest at each risk level has a lot to do with your personal situation and your tolerance for risk. But an investment with a low-risk profile just might help shield your portfolio from the hazardous subprime conditions we are experiencing.

For recent news on companies that make packaged goods, check out:


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 04, 2010, at 10:31 PM, Glycomix wrote:

    Free cash flow isn't enough is it? Otherwise Loreal (LO) and Coach (COH) would be top choices.

    I assume that you picked these stock because they're also large and international. So they seem to be in a better position to withstand a dollar devaluation than smaller, more local companies?

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