After the Subprime Crisis, Which Is the Next Domino to Fall?

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 |  Includes: DIA, QQQ, SPY
by: Andy Abraham

Until early July the world’s economies were going so well. Inflation was stable in most countries. Employment was steady. Gross domestic product was rising in virtually every country, albeit more slowly than previously. Interest rates were low but loved by those who gorged on the notion of cheap debt and cheap money. Wealth was spreading. A whole new wave of millionaires, even billionaires, was emerging from the Mideast, India, China and the rest of the Asia-Pacific region. However a distinct camp of cautious investors grew nervous due to the orgy of cheap money, and their consensus is that 2008 is going to be more about thorns than roses for even the most vigilant of investors.

So many investors have become used to high returns, and neglected the risks attributed to them. This raises the question: Should the current situation be called the “Subprime Crisis or CREDIT CRISIS”?

What is really all that different between non-prudent aggressive lending to homeowners, and lending to real estate moguls who own office buildings or shopping centers, and who are over leveraged? Does it differ so much from lending to companies that over-pay for other companies, with the thought of only selling them on at higher valuations? Money was cheap, and anyone worried about losses could buy insurance for almost nothing. It was definitely not an environment that encouraged careful lending. Now even the rating companies and the insurance companies who secured these transactions are at risk.

What happens if credit insurers turn out to have had inadequate reserves? A possible tidal wave might be at our doorstep, and could threaten the world banking system. This can be assessed by the recent action of the central banks injecting liquidity into the system. Within days, the unthinkable happened. The routine business of the inter-bank markets, in which financial institutions trade money to stay liquid, dried up practically solid overnight. The last time this occurred was after 9/11 and the Russia banking debacle. Banks are afraid to lend to each other. They do not know what their perspective counterparties are hiding in off-balance-sheet SIVs or other toxic paper. The real question is: What is the next domino to fall?

What would occur if the corporate credit markets fall? This will make the subprime crisis look like a walk in the park. The corporate debt markets dwarf the residential mortgage market and are at the backbone of the world's banking system. Moody’s (NYSE:MCO) has declared that it anticipates that corporate defaults will quadruple. Is Moody’s trying to redeem itself from the subprime crisis or are they actually correct?

There are so many dominoes it is hard to determine which one might fall. Could it be the commercial real estate market? Most worrisome is that, now, it's possible to lose money in money market funds, that supposedly held short-term government bonds, but actually included CDOs, CLOs and CMOs to provide slightly better returns. Even the thought of de-coupling with the emerging markets might not be valid. Some emerging markets could run into big problems, because many borrowers there have taken out loans denominated in foreign currency, and could be devastated if local currencies lose value. This domino theory gives credence to the thought that there's no such thing as a truly safe haven when (if) all hell breaks loose.

The proverbial question is: What should an investor do? First realize that if the situation manifests itself, then there will be tremendous opportunities for those who had the foresight to raise cash. My suggestion is to stay in short-term government bonds, simply because you want your money back. The current risks in most asset classes offset the potential rewards. As much as economic cycles are reality and have not stopped ,the Utopia of cheap money is not a reality that can continue.