Call it the "cockroach theory."
It's the assumption among investors that if one cockroach takes you by surprise, there are more to come, even if you see no sign of another at the moment. You apply the same thinking to investing as you apply at home.
Likewise, investors worry when financial messes seem to surface. And they now are on guard, fearful of hidden cockroaches related to years of lax lending practices and tremendous borrowing by everyone from financially stressed home buyers to overreaching private-equity firms and hedge funds.
The cockroaches that surfaced this spring are subprime mortgages and securities based on those mortgages, which are loans to home buyers with weak credit. Some of the worrisome securities are called CDOs, or asset-backed securities called collateralized debt obligations. The value of these securities is based on homeowners making monthly mortgage payments on schedule. But lenders went too far with subprime mortgages, granting them to people who obviously could not afford them. And with defaults on mortgages rising, the securities have plunged in value.
On the face of it, few have suffered seriously besides a Bear Stearns hedge fund. Yet analysts believe banks, insurance companies, mutual funds, pension funds and hedge funds have invested close to $600 billion in these securities.
There is a growing insecurity that institutions that invested in subprime investments have yet to surface with large hits to their investment portfolios.
"People didn't understand the risks" in investing in subprime mortgage-related securities, Jeffrey Gundlach, chief investment officer of the TCW Group, said at a recent Morningstar conference in Chicago. "Now that the tide is going out, all the wreckage is showing up at the bottom of the sea."
Among subprime loans, which make up about 12 percent of mortgages, "the delinquency rate is climbing and it should climb at a very high rate," undermining the value of the related securities, Gundlach said. Delinquencies are now at 14 percent, and he estimates they will climb to 20 percent.
Gundlach notes that investors who didn't realize they were taking a chance with the securities are being surprised with huge losses.
Many investors bought subprime loan securities thinking they were rated AAA, ratings that suggest very safe bond investments, he said. Yet, they are discovering the sophisticated computer models that suggested the investments were safe are not valid, and investors bought junk bonds rather than safe bonds.
"That's a problem," he said. "People bought thinking they were buying something else."
But it's not just cockroaches in the subprime area that are on investors' minds. During recent years, cheap money has gushed into the financial system, a result of low interest rates worldwide and complacency about taking risks.
Private-equity firms, for example, have raised $300 billion this year but will depend heavily on borrowed money, or leverage, to do $1 trillion in deals, said Ranji Nagaswami, chief investment officer for AllianceBernstein Investments. Hedge funds follow similar practices.
"Leverage works both ways," noted Jean-Marie Eveillard, who does not use leverage in the First Eagle Fund he manages. When conditions are on an investor's side, borrowed money enhances returns. But in unpredictable downturns, "leverage can really kill you."
With subprime lending follies in the background, Wall Street analysts wonder if excessive borrowing will show up in some other infestation, perhaps related to hedge funds or private-equity deals.
"Leverage is building up," AllianceBernstein Chief Executive Lewis Sanders told investors at the Morningstar conference. "It is a destabilizing force that will affect all of us, even if we do not think we are involved."
Historically, whenever borrowing has become excessive, lenders eventually have had a day of reckoning with bad loans. In response, they have cut back on credit or raised interest rates on bank loans or corporate bonds, even to solid borrowers. Investors fear such a response because businesses and consumers cut back spending when it costs more to borrow. That can stifle economic growth and corporate profits, sending stock prices down.
"We urge caution," Nagaswami said.