Not a Great Foundation for Optimism

Will the meltdown in the market for subprime mortgages spread to other forms of housing finance and trigger a housing credit crunch that will further depress sales and prices?

The official line from the industry, and the Federal Reserve, is that while this is a serious problem, it involves a small portion of the housing market, with no signs of spreading.

But others aren't so sure.

These are, after all, the same people who denied there was ever a housing bubble, then denied there was a housing bust and, more recently, declared that the housing downturn had bottomed out.

Nor do the numbers fully support their optimism. While subprime mortgages -- mortgages made to people with low credit scores -- account for only 13 percent of outstanding mortgages, they make up 20 percent of the mortgages issued in the past several years. Other categories of mortgages that are almost as risky account for at least 20 percent more, and their default rates have also doubled.

Moreover, many of the recent "innovations" in subprime mortgages were also used by borrowers with good credit histories. These include interest-only mortgages that require no principal payment for 10 years; opt-out mortgages that let borrowers skip monthly payments; and piggyback loans that don't require any money down.

By some estimates, nearly 40 percent of all recent mortgage loans have involved some form of this "risk-layering." One survey found that 29 percent of all new mortgages involved no deposit, while the average down payment by first-time buyers was a mere 2 percent.

Things probably would have worked out just fine for most of those borrowers if interest rates had remained steady and home prices kept rising. But they didn't, and now the impact is rippling through financial markets.

So far, nearly three dozen mortgage lenders have been sold under duress, closed up shop or filed for bankruptcy. New Century Financial, whose 7,200 employees last year generated nearly $60 billion in new loans, last week stopped making loans after its major lenders cut off its credit.

It is as yet unclear how much big banks and hedge funds have lost in this process, but the sums could be large. Already General Motors has warned it may have to take a charge of almost $1 billion to cover bad mortgage loans at its mortgage subsidiary, while HSBC said its bad-debt costs rose 36 percent, to $10 billon.

It's also not clear what may happen to the housing market as a result of all this financial turmoil. Goldman Sachs estimated that as a result of new, tighter lending standards in the subprime market alone, demand for new homes will fall by 200,000 units this year, 20 percent of last year's volume. And CreditSights, a bond research firm, estimates that as many as 500,000 units could come onto the market as borrowers default and their homes are dumped back on the market.