Brace Yourself For The Aftershock

Before I get into this post, let me apologize if I come across as overly negative. I genuinely believe in capitalism and a long-term positive outlook to the stock markets. That's why I continue to add to my stock positions, even as the markets crumble and businesses fail.

But there's no point in trying to convince yourself it's not raining when you're getting drenched. Beating your head against the wall will not change the fact that our nation is in a recession and things are going to need some time to get better.

Our current mess is due in a large part to sub-prime lending and the subsequent repackaging and reselling of those securities. But I believe the sub-prime mortgage mess is only phase one. Phase two is option-ARM (adjustable rate mortgage), and I think we'll be feeling this aftershock in the not so distant future. I wrote last month about the option-ARM mess here, but an article on the Motley Fool caught my attention. Kristin Graham wrote an article titled "The Next Housing Catastrophe Waiting to Strike" and it includes some interesting research about the looming option-ARM crisis.

I strongly recommend you read the article, but since I'm sure some of you won't, I'll paraphrase.

First, take a look at this graph.

As you can see, in 2007, many sub-prime mortgages rates began resetting. This means the low introductory rate that many homeowners were enjoying reset to a higher default rate. Consequently, the monthly mortgage payments went sky-rocketing, and now we are where we are.

But look at the graph again and you may notice in mid-2009 many option-ARM mortgage rates begin resetting. According to Graham's research, some $500 billion in option-ARM mortgages are going to have their rates reset between 2009 and 2012.

That's a lot of resets, but that's not even the scary part.

According to Graham, the average Californian homeowner with an option-ARM currently owes 109% of the value of their home. Roughly 60% of option-ARM mortgages are in California, Graham says. When the monthly payment jumps, how many people do you think are going to stick around when they owe more than their house is worth.

It's their own fault. By not making the full monthly mortgage payment (as option-ARM's allow you to do), they set themselves up for disaster.

However, as we have already found out, one person's mess can really stink up the backyards of all of their neighbors.

So while I continue to advocate seeking out good companies with solid fundamentals like a high return of investments (ROI), I am afraid things will only get worse for the short term.

You are left with several options, and these can vary in terms of return and risk. For a low risk and low return for the short term, you can seek out bonds and CD's. In fact, some places are paying in the 4% range for a 1 year CD so shop around.

Those with a slightly higher risk tolerance can look into put options like I do. With put options, you are betting that the share price of a company will decrease over a certain period of time. These days, that's not too hard of a guess. But options include risks that many people aren't comfortable with. I would encourage anyone considering options to read about the characteristics and risks of options.

The old money in your mattress can work too, although it's hard to get much growth that way. I would encourage anyone to at the very least seek out a high-yield savings account or money market account. For example, INGDirect offers a 2.75% savings account, or a 4.00% 12 month CD. That 4% over the next couple of years might let you sleep better at night than risking the wild waters of the stock markets. Either way, starting to save today will allow the miracle of compounding interest to pad your nest egg.