A year ago, an intelligent American could be forgiven for thinking that "subprime" referred to a poor cut of beef. No more. Falling home prices have since squeezed homeowners, particularly so-called subprime borrowers with shaky credit who began defaulting on their loans. These defaults sparked a full-blown credit crisis over the summer that surprised many market watchers with its scope and severity. 

While the panic may have receded from its August high, the subprime fallout continues. On Wall Street, earnings season has forced financial companies to face the music and post multibillion-dollar write-downs. As a result, CEO heads have rolled, as Merrill Lynch's E. Stanley O'Neal and Citigroup's Charles O. Prince resigned under pressure. On Main Street, homeowners realize that the blazing hot housing market is cooling fast and hope that the worst is over—for their homes, their investments and the economy at large.

But financial experts think differently. "We're nowhere near the end," says Andrew Lo, a professor of finance at the MIT Sloan School of Management and chairman and chief scientific officer of the Cambridge, Mass.–based hedge fund company AlphaSimplex.

According to Lo, we're at least six to 12 months away from a full reckoning, and subprime-related issues may ripple through certain sectors of the economy for years. Here's what we do know: A once-obscure part of the home mortgage market ballooned in recent years, thanks to loose credit standards and a hot housing market. Subprime mortgages and the securities they backed became vulnerable when the housing market slowed and homeowners couldn't refinance to keep on top of rising adjustable rates. Investors became concerned about the losses from subprime defaults, and the ensuing credit crunch spread around the globe.

Even astute investors didn't see it coming. Last fall, Financial Planning asked Legg Mason's Bill Miller—who as manager of the Legg Mason Value Trust outperformed the Standard & Poor's 500 for 15 consecutive years—whether he anticipated a large ripple effect from rising subprime defaults. He said no, that he expected the problem would remain relatively contained. Housing represents only about 5% of the gross domestic product, so his answer hardly came as a surprise.

Uncertainty fanned the credit crisis when it hit. Investors are still struggling to understand how far, and deep, the mortgage mess has spread. Your clients may be wondering how the credit crunch could affect their portfolios. It's not too early to draw some conclusions. For one, the subprime crisis has revealed the dangers of using leverage for institutions and individuals alike. Here's a closer look at what happened...and what may come next.

Much Ado about CMOs

Most homeowners use leverage to buy their homes. Traditionally, they make a 20% down payment and borrow 80% of the house's value. On a stable underlying asset, that's usually a safe bet. But in recent years, low interest rates and a hot housing market contributed to a climate where subprime borrowers were allowed to finance 100% of their homes. Many took out adjustable-rate mortgages with low teaser rates that would reset to much higher levels after a few years.

Subprime loans grew to 25% of the mortgage market in 2005 and 2006 from about 8% in the 1990s, says Dean Baker, co-director of the Center for Economic and Policy Research, an independent think tank. "Alt A" loans, or those made to borrowers with solid credit who have unreliable income or other risk factors, made up an additional 15% of the market.

Mortgage originators sold subprime and Alt A mortgages to firms that packaged them into securities known as collateralized mortgage obligations (CMOs), one type of collateralized debt obligation (CDO). They would bundle securities into slices called "tranches," with the lowest-rated tranche offering the highest risk and potential reward. Many of these securities were over-collateralized to compensate for the weak underlying borrowers. So, for example, a $1,000 bond might be backed by a $1,200 loan amount, explains Ernie Ankrim, chief investment strategist for Russell Investment Group in Tacoma, Wash. This helped the securities earn high credit ratings from the rating agencies, giving investors what turned out to be false comfort. For a while, the system worked: Weaker borrowers enjoyed the American dream while investors got good returns on highly rated investments.

The Leverage Chain

But there was something shaky about these mortgage-backed securities and the way they were transacted. Institutions such as hedge funds and structured investment vehicles, or SIVs (which are the target of the bank-led bailout announced in October) borrowed money to buy CDOs. In one example of a leverage chain, a money market fund would lend money to a SIV in the form of commercial paper; the SIV would then buy a CDO with the borrowed money, and the CDO would take that money to buy another CDO, explains Thomas Atteberry, a partner with First Pacific Advisors in Los Angeles. So several parties used borrowed money to buy an asset with no underlying equity, Atteberry notes. Sound risky? It was.

This layered leverage also made it hard to unwind positions when it became clear that the underlying assets weren't worth what everyone thought they were. The legal agreements established each time investors bought CDOs contained covenants that got broken when the underlying assets weren't enough to cover the debt issues, Atteberry explains. Some covenants required immediate repayment, which left borrowers scrambling to figure out how to price the securities and whom to sell them to, since the usual suspects had all their money tied up. "We call those to-whom bonds,'" Atteberry says, as in, to whom will you sell them?

Bear Stearns had some of these to-whom bonds in its two hedge funds that shut down in July, Atteberry continues. The bonds were used as collateral for money the funds borrowed from broker-dealers. When the collateral got marked down to the point where it was worth less than the amount borrowed, Bear Stearns lent the funds money so they wouldn't be forced to sell their assets to cover the loan. In a margin call, the lender had demanded that the funds either pay down the debt or put up more collateral. A few weeks later, though, Bear Stearns announced that the funds had lost most of their value and closed them.

Uncertainty surrounding the value of mortgage-backed securities caused the credit markets to freeze up. Collateralized debt obligations are not bought and sold on an exchange, so there is little transparency in their pricing, Ankrim says. The concern spread to other fixed-income securities that may have had subprime exposure. Commercial paper and high-yield bonds in particular suffered when buyers and sellers couldn't agree on how they should be priced. The risk premium soared as investors demanded more yield for bonds they suddenly viewed as more risky.

History Lessons

That leverage lay at the root of the subprime blowup came as little surprise to Jason Zweig. The editor of Benjamin Graham's The Intelligent Investor and author of Your Money and Your Brain says leverage and greed have driven every boom and bust in financial history. He writes in an email message: "The housing bubble has been fueled by the leverage of subprime and other unconventional mortgages. The Internet bubble was fueled by margin trading (a kind of equity leverage). The 1929 crash was fueled by margin, bank loans and pyramid schemes of closed-end funds. The crash of 1837 was fueled by bank loans on frontier real estate." That's not to say that leverage is inherently bad. Borrowing money to invest simply magnifies gains and losses. It's the losses that make the history books.

Some industry participants say the credit crunch led to a decreased appetite for any leveraged product, even those unrelated to mortgages. Len Reinhart, outgoing president of Pershing affiliate Lockwood, says his company was ready before the mortgage meltdown to launch a moderately levered Unified Managed Account strategy using ETFs. But the summer's meltdown "spooked everyone and continues to," Reinhart says, making Lockwood clients less inclined to borrow for any reason. The company decided to push the launch into next year.

This kind of hesitancy itself can move markets, says MIT's Lo. The credit crunch made investors nervous about taking on risk, and "that synchronized decrease in risk appetite can also cause significant market dislocation," he says. It's like a boat rocking when all its passengers move to one side, he explains. Some of this summer's market volatility can be traced to this phenomenon. Another factor behind the tumult was hedge funds' selling positions en masse to meet margin calls.

Buying Tactics

There were bargains in the midst of the crisis. Hedge funds created buying opportunities for mutual fund managers when they unloaded positions to meet margin calls. Hedge funds couldn't sell their riskier investments, since that would drive down prices, so instead they sold their solid investments, explains Philip Guziec, a derivatives strategist at Morningstar. But when enough hedge fund managers sold off their best investments at the same time, that created a downdraft in the economy and depressed the prices of some high-quality stocks with no relation to the subprime mess.

Also, some otherwise solid stocks got tarnished by their relationship to the mortgage blowup, resulting in other opportunities. For example, John Osterweis bought McGraw-Hill for his eponymous value fund. He thinks the company has a solid long-term outlook, yet it has suffered for owning Standard & Poor's, which, like the other major rating agencies, came under fire for assigning high ratings to risky mortgage-backed securities. McGraw-Hill's stock price had fallen from $75 to about $47 when Osterweis bought it, for a two- to three-year play. He anticipates major bargains in the financial sector, which has been battered by the subprime crisis. He's waiting until he thinks the stocks have bottomed, a determination he'll make by watching commercial banks' bad debt reserves, earnings reports and stock prices.

As institutions pounce on these buying opportunities, some advisors are cautioning their clients not to follow suit. "We figured we're not smart enough to know when it'll turn around," says Harold Evensky, president of Evensky & Katz in Coral Gables, Fla. Evensky was smart enough to write a chatty and informative newsletter to clients detailing the subprime meltdown and its origins to reassure his readership.

Another South Florida planner, Tom Balcom of Foldes Financial Management, is also telling clients to be wary of capitalizing on the subprime fallout. There are real estate bargains, but it pays to know the market, he says, since some sellers are still asking too much. One client found a bargain in the Florida Keys and bought the house, with Balcom's blessing, as a retirement home. Mostly, though, he's telling clients to stay the course.

Most experts agree that few clients will be hurt directly by the mortgage meltdown. Ankrim goes further: "This isn't going to undercut the basic strength of the U.S. industrial economy or 95% of clients of advisors," he says. Clients with money market funds that hold subprime-backed commercial paper maturing in the next few months should watch out for lower yields. U.S. money market funds from Bank of America, Credit Suisse, Fidelity Investments and Morgan Stanley had more than $6 billion of CDOs with subprime debt in June, according to Bloomberg Markets. But the chance of these funds' per share net asset value slipping below $1, or "breaking the buck," is very slim, Ankrim says.

Investors would do themselves a disservice to revisit their allocations in light of the recent tumult, he says, since they might want to adopt more conservative positions that won't benefit them in the long term. Others counter that it wouldn't hurt to take stock of clients' financial situations."Does the appraisal of the client's house need a haircut?" Zweig asks. "If so, how should the rest of the client's portfolio reflect that?"

What's Next?

Your clients may have escaped a direct hit, but no one is immune to larger economic gyrations, at least for now. Credit woes account for some of the current market malaise, as investment banks take multibillion-dollar write-downs on their mortgage losses and investors wonder where subprime debt will turn up next. On top of the credit crunch, concerns abound that consumer spending, the force behind the recent economic boom, will decline. A slumping housing market remains a big drag on the economy, and oil's record prices—crude hit $96 a barrel at the start of November—have fueled inflationary concerns.

Central banks have succeeded in controlling inflation recently. Yet even this has led to potential dangers, according to The Economist. "The great paradox is that the central banks' mastery of inflation has made the task of keeping financial markets safe all the harder," says its October report. "When people are confident that inflation is low and will remain so, they may be more prepared to take on debt. That leads to an expansion of credit and the pursuit of more exotic rewards by lenders."

Where might the next leverage dangers be lurking? Lo and Zweig both finger overheated emerging markets as an area to watch. Diversified emerging markets mutual funds returned 38% per year over the past five years as of Oct. 31, according to Morningstar, a sector performance second only to that of Latin American funds, which returned 51.8% during the same span. "Emerging markets already have plenty of greed going for them," Zweig writes. "If leverage gets layered onto emerging markets funds en masse, watch out."

Emerging market countries themselves issue a lot of debt, Lo says. A Russian debt default contributed to the collapse of the hedge fund Long-Term Capital Management in 1998. Atteberry says investors should watch corporate levered loans. The increasing use of second liens—debts that are subordinate to more senior debts issued against the same collateral—and reduced covenants are cause for concern.

What's the next investment product that's ready to blow? Evensky writes in an email message: "I'm afraid there may be one but, like everyone else, I'll only know after the fact."