By William Patalon III
Managing Editor

Standard & Poor’s Inc., the top dog on Wall Street in the debt-rating department, issued a big mea culpa Friday, saying it erred last week when it announced it was putting $12 billion in subprime-related bonds under review for a possible downgrade.

It seems the actual total was only $7.35 billion.

Gee, I feel better now….how about you?

Granted, this is a big mistake and S&P needs to do a thorough internal review to find out just what went wrong and what it needs to do to make sure something like this doesn’t happen again.

My problem is with the folks who are viewing this as some kind of “good news” – an indication that the subprime debt problem isn’t as big as we thought. Those are the same folks who believe Thursday’s record-setting surges in the Dow Jones Industrial Average and S&P 500 were bold statements by the capital markets that everything is jolly here in the U.S. economy.

Don’t get me wrong. I’m not calling for a repeat of 1929, 1987 or even Tulip Mania. But I am saying that there are some problems within the U.S. economy and its accompanying financial system that are serious enough to merit ongoing vigilance – and that may require some of us to adjust our portfolios or our investment strategies.

The subprime-debt issue is one of those problems. It’s worrisome because – like many problems – it cuts across multiple sectors. It’s related to the housing market, which as we well know is in tough shape. But the fallout could have wide-ranging effects.

For instance, as homeowners with subprime mortgages increase their rate of delinquencies or defaults, more of the bonds backed by those subprime mortgages will be downgraded, or go into default themselves. Thanks to Bear Stearns, we’ve already seen how hedge funds that make bets on the subprime market can get scorched when the market moves in the direction opposite to the bets they made. And don’t think for one minute that there aren’t other debt bombs out there, just ticking away.

Banks and insurance companies are also affected. Some just held the bonds themselves (and didn’t make leveraged bets like the hedge funds did in order to magnify their profits).

S&P, as well as rivals Moody’s Investors Service and Fitch Ratings, both saw that this already-ugly scenario was getting worse.

Moody’s on Tuesday downgraded nearly 400 subprime-backed bonds, and is reviewing nearly three-dozen more for possible downgrades. The original value of these bonds was $5.2 billion.

Fitch, in its monthly bond-performance review, identified 170 subprime bonds that it will be reviewing in the next few weeks. Downgrades on the $7.1 billion in bonds are likely.

Most of these bonds were issued in the 12 months between the fourth quarter of 2005 and the final quarter of 2006 – in retrospect, a period during which some of the riskiest home loans were made, with lenders apparently relaxing their standards to keep the deals coming into their doors.

Moody’s didn’t even bother issuing the usual “under review for a possible downgrade” notification. They just downgraded the bonds.

All told, we’re talking about a significant amount of debt that’s either under review or already downgraded: $7.35 billion for S&P, $5.2 billion for Moody’s and $7.l billion for Fitch.

That’s a grand total of  $19.65 billion.

As the late Illinois Sen. Everett McKinley Dirksen once said: “A billion here and a billion there, and pretty soon you’re talking about real money.”

What Dirksen meant was that we’ve become so used to the huge dollar figures we hear each day that we’re no longer able to tell what matters and what doesn’t.

Trust me on this point: S&P’s $4.65 billion overstatement isn’t one of those big numbers that matters. It’s not a case of the debt problem not being nearly as bad as we’d feared.

I mean, there’s nearly $20 billion in other debt that’s already in trouble, and I’m sure there’s more hiding in the wings, just waiting for its moment in the downgrade spotlight.

The fallout from this could be devastating.

The lower ratings for these subprime-mortgage bonds will have a ripple effect that, worst-case scenario, might be more akin to a tsunami. It could turn off the spigot for the easy money that powered the housing boom, and helped fuel the latest bull market in stocks.

We’re going to see higher interest rates as the financial markets make their free-market adjustments for the higher risks permeating the economy.

As the subprime problems spread, and more homeowners get behind in their payments and then default, bond downgrades will increase in number and scope. To protect their earnings, and their balance sheets, financial institutions are going to have to reduce their exposure to risk.

And they’ll do that in two ways. First, banks, mortgage companies and other providers of capital will require borrowers to pay more for money as compensation for taking on the additional risks that making the new loans entail. That “compensation” manifests itself in the form of higher interest rates. And second, the lenders that already feel burned may substantially raise the qualification requirements for borrowers, meaning lots of folks won’t qualify.

Together, these two responses by banks cause what is commonly known as a “credit crunch.”

This happens every few years. One unusual credit crunch played out in the early 1990s, when I was working as a business and finance journalist for Gannett Newspapers in New York state. I remember when banks were emerging from a lengthy recessionary period, but were loathe to make loans in what they saw as a very risky market. They kept on taking in deposits, but instead of loaning out money, they invested the cash in Treasury bonds.  The ensuing credit crunch turned the economic recovery from the early 1990s recession into a half-decade-long venture.

Thanks to mortgage “resets,” as interest rates rise, high-credit-risk borrowers with adjustable-rate mortgages (ARMs) are going to get clobbered.

In the next couple of months alone, more than 2 million homeowners with subprime ARMs are looking at resets – and at much-higher interest rates – a reality that’s likely to deepen and lengthen an already-dismal housing downturn. According to Economy.com, an econometric group based in West Chester, Penna., more than $50 billion in ARMs will reset in October alone, a record.

Some of these loans were taken out in the 2004-2005 period, and offered super-low “teaser” rates for the first several years of the mortgage. Often, the borrower would just go out after that and refinance the house. But with higher rates and tighter qualifying standards, that may not be possible.

Instead, these borrowers could be faced with monthly mortgage payments that are up to 40% higher than what they carried before. According to one scenario, a person who currently has a mortgage payment of roughly $950 per month and faces a reset would subsequently be burdened with a monthly payment of $1,350 per month.

U.S. foreclosures jumped to a record 926,000 in the year’s first half, a jump of 56% from the first six months of 2006, according to Bloomberg News. The highest foreclosure rates last month were in Florida and California, where in some markets housing prices have fallen by as much as a quarter, and in Michigan and Ohio, where there have been years of job losses in auto-related sectors, Bloomberg reported.

All of this will spread, too. Consumer spending accounts for two-thirds of U.S. economic activity, and low interest rates allowed Americans to spend more of their paychecks, while soaring home prices meant the real estate market was doing their saving for them – which also allowed them to spend more.

Low interest rates also helped fuel the ongoing buyout boom, which has been behind much of the current bull market in stocks in the United States, and to a lesser extent, overseas.

But taking a company private in a period of steeply rising interest rates is much riskier, and a big spike in rates could bring the private-equity boom to an end.

Are we destined  for the “worst-case scenario” I’ve sketched out here?  I doubt it. There are many other factors giving the economy and stock prices substantial strength, or enough to shrug off at least a portion of these negative burdens.

But I believe the buyout boom is going to slow, and the housing slump will steepen before it gets better.

These economic problems – which are largely domestic in origin – are a big reason that we here at Money Morning believe U.S. investors really need to take larger positions in the international markets. While we realize that remains very much a minority viewpoint – despite the huge run-ups we’ve seen in overseas stock markets in the past year – I can assure you that we’re not alone in that belief. Wall Street investment banks are repositioning thousands of staffers and opening hundreds of offices overseas to better serve (Wall Street speak for “to better profit from”) global growth. They’re just not trumpeting that fact.

However, in a recent media interview, Best-selling author and famed Wharton Business School Professor Jeremy Siegel said that the long-held conventional wisdom on international investing should be thrown out the window. For decades, we’ve heard over and over how international investments should comprise 5%, 10% or at most 15% of our portfolio’s total value. Any more than that is foolhardy and risky.

But according to Siegel, the foolhardy act is to limit our international exposure to 5%-15% of our total holdings. The risk now isn’t the risk of loss from a collapse of the international markets. It’s the risk of getting left behind because most of the growth to come in the decades ahead will be generated by countries such as China, Japan, Taiwan, Korea, Brazil – and in a few more years, perhaps even markets such as Vietnam. Investment advisors who stick with this old asset-allocation model are actually doing their clients a huge disservice, Siegel says.

Siegel now believes that international investments should comprise about 40% of your total holdings. Most individual investors know Siegel for his best-selling book, Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies. The book first came out in 1994, and is considered one of a handful of “must-read’ titles. But when the fourth edition appears in December, there will be something new to look at: This edition will include a long addition addressing the international arena, and how investors must adapt their strategies to the new realities of globalization.

It’s important to adapt to new realities. Even Sen. Dirksen thought so, once noting that “life is not a static thing. The only people who do not change their minds are incompetents in asylums, [while those] who can’t are in cemeteries.”

Good Investing;

William (Bill) Patalon III
Managing Editor

Tags: Interest Rates