If you’ve been paying attention to the news recently you’ve probably heard about this sub-prime mess and credit crunch that is well underway. You may also have picked up on the fact that the central banks have injected billions of dollars of liquidity into the credit markets in an effort to keep them functioning. The Fed Chief Bernanke has opined that the problems in the housing and credit markets are “likely to get worse before they get better”. Treasury Secretary Henry Paulson has proposed bailing out the people who chose to buy houses they could not afford by suggesting that interest rates be frozen on these subprime mortgages for a 5-year period. This is obviously going to create losers, namely the investors who bought investments backed by these risky mortgages and in return were going to be earning a higher return (or no return in the face of defaults). In fact, the government announced today that the freezing of interest rates for a fraction of the 1.2 million people who are eligible for help will indeed occur; thus, the investors who bought investments backed by these mortgages will certainly not be earning the potentially higher returns that they had hoped for. At the same time, due to the rate freeze, the default risk on these investments has decreased as well. The question that needs to be addressed is whether the government is setting an unwelcome precedent with its proposal. After all, this proposal means that the government has introduced a moral hazard for future borrowers or lenders by bailing out folks who have made poor decisions.

But, the buyers of subprime mortgages who could never afford them are not the only ones to blame (and, did they really understand what they were getting into anyway?). There appears to be a fundamental flaw in the system, created by the separation of borrower and lender a few decades back. In the past, local banks used to sell mortgages and other lines of credit to its customers, and they had a true self-interest in making sure those lenders would be able to repay their loans. Now, mortgage companies sell the mortgages to financial institutions, and they repackage them into investment vehicles and sell them to investors. So the risk of default has been transferred to the investors. The problem is that the “middlemen”, the mortgage companies and financial institutions, have an incentive to sell as many as possible because they earn profits without taking on the risk. If defaults occur, which is most likely in the case of subprime mortgages, the investors lose their money. And selling subprime mortgages or investments is the most lucrative. Hence it shouldn’t come as a surprise that the Wall Street Journal recently reported that the number of subprime loans has increased rapidly since 2000 and that a large percentage of those loans went to people who could in fact afford conventional loans with better terms. And who got punished for that? No-one. Yet. So way to go New York Attorney General Andrew Cuomo who just subpoenaed major Wall Street banks to investigate the mortgage business. He is looking at questions related to the disclosure of risks to investors and the level of due diligence done by banks who buy and resell the subprime mortgages.

So what does this all mean for consumers? For one, borrowing on credit has and will become much harder. Lenders, in the face of financial losses, have less money to lend, and have tightened their lending standards and limited credit lines. And it is only getting worse. Data shows that there is $360 billion worth of mortgages due to reset in 2008 to much higher levels, which is more than one-third of the $1 trillion of US subprime loans outstanding. Who knows which banks, after Citigroup, Merrill Lynch, Morgan Stanley and UBS, are the next victims. A Goldman Sachs report suggests that banks and other lenders could cut lending by as much as $2 trillion, creating a possibility for a substantial recession. The Wall Street Journal reports today that delinquencies in the auto-loan market have increased to the highest level in several years, which has forced lenders in some cases to tighten terms for loans. With credit being this tight, you may have to wait a long time to purchase that oh-so-desirable Lexus or you will have to pay much higher rates for borrowing.

Consumers have also and will continue to be hurt by falling housing prices. Studies have shown there to be a direct relationship between a decline in house prices and a drop-off in spending. It is no surprise therefore that data shows that consumers have been cutting back on apparel, autos, and other luxury items. This in turn has hurt those industries.

What can you do to protect yourself? First of all, for those of you who are taking out home equity loans as a way to finance spending, stop now. You are risking losing your home by doing this. Falling house prices are detrimental in this regard, and it is time to start saving. It is time to replenish the lost equity, although this is obviously much harder now. But if you are fairly young, you have time. For those of you who have retirement savings, adjusting your portfolios defensively may be a good idea at this time. Some experts are suggesting overweighting foreign equities and increasing the fixed income portion of your portfolio. If you are close to retirement, the conventional wisdom that you want most of your retirement assets in low risk, fixed income instruments, holds even more so now.