Oh Fools, Where Art Thou?

Here's a familiar refrain among our investing peers (tell us if you've heard this one before): The number of outstanding high-risk loans (specifically in the mortgage arena) will eventually lead to an unprecedented number of defaults once we hit the next recession. As a result, the next recessionary period in the economy will take many years to recover from.

This baffles us. If people are so over-indebted and crazed with profligacy…where are all the fools? We don't see a lot of euphoria or nutty behavior out there. In fact, most people are rather dour on housing right now even as the economy continues its expansion. So in the absence of a true psychological mania, the other option is maybe, just maybe, people are engaging in generally rational risk/reward decision making. Money is cheap right now, so it's logical that lower credit borrowers can borrow easily. The cheap relative cost of money creates a bigger incentive to take on risk.

In the context of the total economy or debt markets, is the high risk stuff really a bigger proportion than usual? Of course today it's at all time highs in absolute terms, but so is the size of the economy. There isn't a great or precise way to quantify this, but our sense is the proportion of risky debt is bigger than normal, but not as extreme as most fear. The next issue is: when will the recession hit? We think that is a ways off, at least well into next year if not longer. In fact, all signs in the near term point to continued economic prosperity above most economists' expectations.

Who's more foolish? The fool who takes on risk to generate a return over its cost, or the fool on the sideline calling him one?