Who gets hurt if subprime meltdown worsens?

John W. Schoen • Profile • E-mail

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.

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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.

Homeowners
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.

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