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Who gets hurt if subprime meltdown worsens?

What has investors so unnerved these days is the sinking feeling that unwinding of the housing boom could be part of a wider unraveling of the financial markets – one that ultimately brings on a recession. By's John W. Schoen.
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The turmoil in the so-called “subprime” lending market has — so far — been limited to the borrowers who foolishly got in over their heads and the lenders who recklessly sold them the loans.

But what has investors so unnerved these days is the sinking feeling that the unwinding of the housing boom could be part of a wider unraveling of the financial markets — one that ultimately brings on a recession.

While some mortgage lenders and borrowers are feeling the pain, the problem is “largely contained,” Treasury Secretary Henry Paulson said Tuesday, reflecting the view of many private economists and analysts.

"The consumer in this country continues to be very healthy," Paulson said. "This is a diverse economy and we've got a very, very healthy consumer, and inflation would appear to be contained."

Any time part of the financial markets goes off the rails, the chance of the damage spreading is real. And the collapse of the housing boom — and the billions in bad loans that helped fuel it —is apparently far from over. Still, with inflation low and job growth fairly strong, most economists think the wider economy can dodge a recession.

“Most of the problem we are seeing in subprime area appears to be the result of fraud and really sloppy underwriting,” said Mark Vitner, a senior economist at Wachovia.

But some are beginning to offer a darker forecast. New York University economist Nouriel Roubini thinks the housing market is headed for another drop this year, creating a downturn that will spill over into other parts of the economy. He sees a recession coming by midyear.

“It is not just housing,” he said. “That is crucial. Now we have an auto recession, we have a manufacturing recession. … We have two consecutive months of retail sales being flat. So even the consumer is on the rope.”

Here are some of the risks faced by various groups with a stake in the collapse of the subprime mortgage market:

Subprime borrowers
The immediate pain is being felt by the holders of the 20 percent of the loans written last year, worth about $600 billion, that went to so-called subprime borrowers — an industry term for people who have bad credit. To make up for the added credit risk, lenders charge higher interest rates to these borrowers.

To attract more customers, lenders tried to make it easier on borrowers by lowering monthly payments with a variety of “exotic” mortgages. These loans by charged only interest or set a low starter rate for the first few years. The hope was that as housing prices rose, borrowers could refinance and head off increases in monthly payments down the road.

But with housing prices stalled, and the low initial rate on many of these loans expiring, borrowers are getting squeezed.

“Many of these loans were kind of doomed to failure if anything went wrong,” said Stuart Hoffman, chief economist for PNC Financial Services Group.

Some $1.3 trillion in subprime loans are outstanding, of which $235 billion are expected to be reset to rates as high as 12 percent. So if lenders now decide these borrowers are too risky — and balk at refinancing their mortgages — more defaults could be coming.

Despite some tentative signs of improvement late last year, the housing market appears to be headed for another rough year of sluggish sales and falling prices in many regions. Sales of new homes fell 16.6 percent in January and prices were flat, according to the latest government data, the sharpest drop in 13 years. The inventory of unsold homes jumped nearly 20 percent.

For anyone who owns a home, the rising default rate puts added pressure on the value of all homes. That’s because foreclosed real estate usually goes back on the market priced for a quick sale. Those who plan to stay put for the next year or so may see little impact from the drop in prices.

But if you have to sell your home, you face the prospect of further price declines this year. And real estate industry watchers say things may get worse before they get better.

“I think it’s going to get uglier,” said Angelo Mozilo, CEO of mortgage lender Countrywide Financial.

At the height of the housing boom, subprime lending was a very profitable business. To keep generating new loans, mortgage lenders sell their loans to big Wall Street brokerages, who bundle them together, chop them up into pieces, sell them to investors like hedge funds and pension funds, and collect a fee.

In theory, selling off these loans spreads the risk of default among many investors. But because many of these loans were made with little or no proof of the borrower's income or assets, it’s not clear how many more loans will go bad.

“The disadvantage is that you don’t know who bears the risk,” said Mark Zandi, chief economist at “Someone does. And we're all hopeful that the system is fundamentally sound enough and the risk has been distributed widely enough that no one does choke. But the point is no one knows.”

Already, there’s talk on Capital Hill of tightening regulations to prevent a future mortgage meltdown — including a law to spelling out more clearly who bears the risk of making bad loans, according to Rep. Barney Frank, D-Mass., chairman of House Financial Services Committee.

"One of the things we're going to do, I hope, is to pass a law that will say, ‘If the mortgages were flawed and you bought them, you bought the flaw as well,’” he told CNBC. "You don' t want to have a situation where people make bad  loans, knowing they are imprudent, and figuring, “OK, I’ll dump them into the market.”

Already, the downturn in the housing industry has taken a dent out of job growth.

Though the economy added 97,000 new jobs in February, employment in housing-related industries fell by 11,000 — bringing to 176,000 the total number of jobs lost in the sector since April 2006, according to figures compiled by

That's a sharp contrast to the height of the housing boom in 2005-06, when the industry was responsible for creating some 25,000 to 50,000 new jobs every month.

Some of those jobs are directly related to housing construction. But the collapse of the subprime mortgage market means job losses for that sector of the financial services industry. At least 20 of these lenders have already gone out of business; major lenders with big subprime portfolios face big losses that may translate in to further layoffs. The full extent of the problem may not be known until the next round of profit reports from banks and other lenders.

Some have suggested that the Federal Reserve move to cut interest rates to help soften the impact. But with wages growing, the central bank is still officially more worried about inflation than recession.

Cutting rates could also extend the easy-money lending climate that created the mortgage markets problems in the first place, according to Sandy Rufenacht, a portfolio manager at Three Peaks Capital Management.

“We need to let some of this risk-based asset-taking mentality over the last several years kind of wash its way through,” he said. “If the Fed were to cut rates, it might now unnecessarily rescue some of these instances that I think maybe should play out.”

While consumers continue to carry large levels of credit card debt, they seem to be keeping up with the payments.

“Delinquency rates on subprime auto loans and credit cards do not show anywhere near the deterioration as in mortgages,” said Vitner.

That’s further indication that the problem in the mortgage market is the result of bad lending decisions by mortgage brokers — rather than a wider weakening of consumer finances.

But if housing prices keep falling, that could further squeeze consumers’ pocket books. That’s because homeowners have not been shy about tapping into gains in home equity by refinancing — to the tune of more than $314 billion last year, according to the latest forecast from Freddie Mac, the government-chartered housing finance corporation.

The same forecast sees so-called cash-out refinancings falling this year — to $233 billion — and again to $154 billion in 2008.

By way of comparison, it took homeowners eight years to cash out $187 billion in home equity from the end of 1992 through 2000.