Who gets hurt if subprime meltdown worsens?

Investors
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 Moodys.com. “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.”

Jobs
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 Moodys.com.

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.

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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.”

Consumers
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.

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