Making sense of the mortgage mess

By Mara Der Hovanesian, Peter Coy, Matthew Goldstein, & David Henry

updated 4:39 p.m. ET March 19, 2007

When General Motors Corp.'s fourth-quarter results missed analysts' estimates on Mar. 14, the reason probably took some people by surprise: mortgage loans gone bad. Although the world's No. 1 automaker posted its fattest profits in three years, the news was overshadowed by a $651 million shortfall in its subprime mortgage unit.

In the past few months, subprime specialists New Century Financial, Fremont Realty Capital, NovaStar Financial, Accredited Home Lenders, and at least a dozen others have seen their stocks plummet as they've announced major losses, exited the business, put themselves up for sale, or declared bankruptcy. As the blowups mount, fears are growing that the carnage isn't over. On Mar. 13 the Mortgage Bankers Assn. reported a record percentage of mortgages entering foreclosure in the fourth quarter—news that sent the Standard & Poor's 500-stock index tumbling 2%.

Nonetheless, in the broadest sense, say economists, the economy should be able to withstand the downdraft in the mortgage market. "It's going to have limited impact," says David A. Wyss, chief economist of Standard & Poor's, which, like BusinessWeek, is a unit of The McGraw-Hill Companies. But he's quick to add: "That doesn't mean none."

Indeed, the list of losers seems to be growing every day, from the Wall Street banks that extended credit and the investors who gorged on mortgage-backed securities to the shareholders, big and small, of failing lenders. And don't forget the home buyers themselves, who busted their budgets to buy more home than they could afford and now face the possibility of foreclosure. They all stand to suffer in the months ahead.

The good news is that, although the subprime business has grown rapidly in recent years, it remains a small part of the overall mortgage market — 14% of outstanding mortgage loans. And only some subprime loans are in trouble. About 13% were past due in the fourth quarter, the Mortgage Bankers Assn. said. So the most serious damage is confined to a fraction of a sliver of the overall mortgage market. Christopher L. Cagan, chief economist at Santa Ana, Calif.-based First American CoreLogic, projects mortgage defaults of about $300 billion through 2010, just a flea on the nation's $10 trillion housing elephant. And about two-thirds of the losses will be recovered when lenders repossess homes.

Glass housing
Ordinarily, economists get alarmed when subprime does badly, assuming borrowers with weak finances can't make their mortgage payments because the underlying economy is weak. It's different this time because the main culprit is lax underwriting standards. The overall economy is doing reasonably well, creating 97,000 jobs in February, according to the Bureau of Labor Statistics. The unemployment rate is just 4.5%. Subprime's woes aren't an indicator of deeper-seated problems.

More from BusinessWeek Top 10 Mortgage Mistakes Subprime Time Bomb The Mounting Uncertainty over Subprime More Trouble in Subprime City Subprime Lending's Next Act Who's Profiting from the Subprime Bust

In fact, the prognosis for the "prime" mortgage market seems positive, despite an uptick in defaults. From Feb. 1 through Mar. 8, as the subprime market got sicker, rates on 30-year prime fixed mortgages fell, to 6.14% from 6.34%, according to Freddie Mac. Families are taking advantage of those low rates. The Mortgage Bankers Assn. said on Mar. 14 that its weekly index of applications was up 19% from the same time last year.

Bears worry that the subprime turmoil could deepen the housing slump, stripping a point or two from gross domestic product. The downturn in construction is already the biggest drag on growth, affecting everyone from carpenters and plumbers to furniture salespeople and attorneys. If families with poor credit stop buying because they can't borrow, it will further delay the rebound in homebuilding and associated. David Rosenberg, chief North American economist at Merrill Lynch & Co., who is among the more bearish economists on Wall Street, wrote on Mar. 14 that "it is not inconceivable" that house prices will fall 10% this year, which he estimates would cause economic growth to slump to about 1.75% in 2007 from 3.3% in '06. Writes Rosenberg: "That's not a classical recession, but it's what we call a growth recession." Wyss of S&P thinks the weakness in housing, compounded by subprime's problems, will slow economic growth to 2.4%, though he recently raised his estimate of the probability of a recession starting in the next 12 months to 30%, from 25%.

Paradoxically, the flight to the safety Treasuries, sparked in part by the subprime mess, may actually help the overall economy by lowering interest rates. Greg Jensen, co-chief investment officer at Bridgewater Associates Inc., a large manager of institutional investments, wrote in a report to clients on Mar. 14: "Our guess is that the current bond rally will do more to fuel global growth than the subprime problems will do to slow it."

Subprime meltdown Lenders willing to help struggling homeowners Six-month moratorium on foreclosures urged Regulators testify on subprime meltdown BusinessWeek: Making sense of the mess Blacks suffer most in U.S. foreclosure surge Q&A: Will woes ripple through economy?

That's not to say the pain won't be severe for those closest to the subprime market's excesses. Subprime borrowers in once-speculative hot spots are especially vulnerable. In markets like Honolulu, Las Vegas, Southern California, Washington, D.C., and much of Florida, mortgage payments account for more than a third of income, vs. the national average of 16%. In California, one in five homeowners forks over more than 50%. These home buyers are "starting to freak out," says Pamela D. Simmons, a real estate attorney in Soquel, Calif., near Santa Cruz. She sees about 20 distressed home buyers a month, up from a handful six months ago.

The lenders that made the riskiest loans—and their employees—are on shaky ground, too. Meanwhile, players in other parts of the credit markets are anxiously watching. "One of the risks is that people panic and take their money home," says Wyss.

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