July started with a boom and ended with a bust. Since its peak in mid-July, the broad market is down just over 6%. The recent weakness has wiped out the early strength in July – the broad market is down just over 3% for the month. The S&P 500 has fared a little better than the broad market due to weakness in smaller cap stocks. In fact, it was a crummy month for just about any higher risk asset. Money market and investment grade bond funds will be the few areas with positive returns during the last few weeks of July.

We can’t say we’re particularly upset about the recent drop. At the end of June we cut back on our stock allocations, increased our longer-term investment grade bond stakes, and even added some funds that short stocks. In fact, we’d like to see some more weakness in the market so we can go on a mini-buying spree. 

Until mid-July, things were looking great for stocks. 2007 was on track to beat last year’s solid 15%+ returns. More importantly, the market had come right back from its fast and furious drop in late February – the one that was supposedly caused by a one-day crash in China.

This time around, the problems weighing down stock prices seem a little more serious. Slowly but surely, it is becoming clear that some of the people who borrowed money in recent years are going to have trouble paying that money back. Worse, from a lending point of view, the “assets” backing the loans might not be worth quite as much as originally thought.

The math works like this: Mr. Newhome borrows $300,000 to buy a condo for $310,000 (after scraping up a $10,000 down payment). This seems like a can’t-lose way to make money with somebody else’s money, as the condo was worth a mere $150,000 just a few years ago and prices are clearly on an uptrend. 

Fast-forward to the future (the near future it turns out), and Mr. Newhome is having trouble making the payments on the loan, which are climbing because of the unusually structured loan he took out. He’s had some unforeseen expenses and, unfortunately for the lenders, Mr. Newhome doesn’t really earn $75,000 a year as he stated on his “no doc” loan application. When the lenders get around to kicking Mr. Newhome out of the condo, they find many other similar condos are currently on the market waiting to be sold at prices around $250,000. Apparently building condos with other people’s money was a good idea when they could be built for $275,000 and sold for $310,000. The creditors liquidate the property and book a loss of about $50,000 before expenses. Big deal. 

Trouble is, some highly leveraged funds owned that mortgage, only they borrowed money at 4% to buy more Mr. Newhome-type mortgages yielding 7% - a can’t lose way to make 3% with somebody else’s money. When you start taking 15 % hits on your loans as the above example shows, you can get cleaned out pretty quickly if you are highly leveraged. And who is going to make the payments on your 4% loan when the cash flow from your 7% loan is cut off?

Nobody really knows how far this string of events will go – or how much other people’s money will get dinged. For a while it was thought only money lent to questionable home buyers, or subprime borrowers, was at risk. Now other higher risk debt is in question – even money used to buy businesses and commercial property. That is why junk bond funds are taking it on the chin. Recently, a large mortgage company noted that even its prime buyers are increasingly having trouble making payments.

How bad this debt problem will get depends on how far the assets behind the loans fall. Since we have seen quite a bit of asset inflation in recent years, anything is possible. There is an element of “the only thing to fear is fear itself” going on, because the assets (homes, condos, commercial buildings, etc.) in question can continue to maintain lofty valuations if the economy remains strong and credit is available. But the credit may not remain available if lenders fear defaults. And the economy may not remain strong without all the easy lending and asset inflation we’ve experienced in the past few years. 

Too bad we can’t just pretend it never happened.