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Will subprime mess ripple through economy?

/ Source: The Associated Press

The hangover from the lending spree that fed the real estate boom during the first half of this decade keeps getting worse, with the most acute pain tormenting the mortgage niche catering to high-risk, or “subprime,” borrowers.

More than two dozen lenders already have evaporated in a subprime mortgage meltdown that began late last year. Now, New Century Financial Corp. is in danger of joining the list because the Irvine-based company has been cut off from its funding sources.

Here’s a look at some of the key questions raised by the turmoil.

Q: What’s a subprime mortgage?

A: Generally speaking, these are home loans made to borrowers with poor credit ratings — a group generally defined by FICO scores below 620 on a scale that ranges from 300 to 850.

Q: Isn’t this just a small part of the mortgage market?

A: Although most home loans don’t fall into this category, subprime mortgages have proliferated in recent years as rising real estate values emboldened lenders to take more risks. Wall Street encouraged this behavior, too, by bundling the loans into securities that were sold to pension funds and other institutional investors seeking higher returns.

Subprime mortgages totaled $600 billion last year, accounting for about one-fifth of the U.S. home loan market. An estimated $1.3 trillion in subprime mortgages are currently outstanding. That’s nearly as large as entire California economy.

Q: Who are the nation’s major subprime lenders?

A: Besides New Century, the other major players include Countrywide Financial Corp., Ameriquest Mortgage Co., HSBC Holdings Corp. and Fremont General Corp. All have acknowledged significant problems in their subprime portfolios, with New Century and Fremont General showing the greatest signs of duress.

While New Century grapples with a liquidity crisis and probe into its accounting practices, Fremont General is trying to sell its subprime business. Investors have punished both companies. New Century’s stock price has plunged by 95 percent so far this year, while Fremont General shares have plummeted by 58 percent.

Q: What went wrong?

A: Subprime lenders made too many loans to borrowers who didn’t make enough money to make the monthly payments. In some cases, lenders didn’t even bother to verify borrowers’ incomes.

It took a while for the problems to surface because many of the subprime mortgages carried artificially low interest rates during the first few years of the loan. The delinquency rate on subprime mortgages recently reached 12.6 percent.

Some of this trouble might have been avoided if home prices had continued to climb like they did between 2000 and 2005. As a home appreciates, even borrowers who aren’t paying the principal loan amount build up more equity. That in turn would have made it easier for subprime borrowers to refinance into yet another loan with a low interest rate.

Now that home prices have weakened in many parts of the country and lenders are being more vigilant, refinancing isn’t an option for many subprime borrowers facing dramatically higher payments. The rates on an estimated $265 billion in subprime mortgages are scheduled to be reset this year. Some of those borrowers could be facing interest rates as high as 12 percent if they can’t refinance.

The financial trouble facing these subprime borrowers could be bad news for anyone hoping to sell a house in the next few months. If thousands of subprime borrowers default on their loans, it will mean even more “for sale” signs on in an already sluggish market for home sales.

“The spring home selling season is at risk of being a major bust,” Merrill Lynch economist David Rosenberg wrote in a Monday report.

Q: Could the subprime mortgage market’s misery infect other parts of the economy?

A: In a worst case scenario, the wave of anticipated defaults on subprime mortgages and tighter lending standards could combine to drive down home values. That could make all homeowners feel a little less wealthy, contributing to a gradual decline in their spending. Less consumer spending eventually weakens the economy, prompting companies to start laying off workers in a vicious cycle that causes households to become even more frugal.

“There could be some negative psychological effects to all this,” said Standard & Poor’s subprime mortgage analyst Stuart Plesser.

Edward Leamer, an economist with the UCLA Anderson Forecast, doubts home prices will fall dramatically because most owners won’t have to sell. Still, he predicts home values will remain flat or slightly depressed for the next three or four years.

“There are going to be a number of borrowers feeling a lot of distress,” he said.