How Bad Will the Mortgage Crisis Get?

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John Gress / Reuters

A foreclosed home in Chicago

The credit markets are seizing up and the uncertainty recently drove up short-term interest rates for municipalities and some rock-solid institutions such as New York's Metropolitan Museum of Art to 20%. And now even so-called prime borrowers, the ones who were properly vetted, are being sucked into defaults on their mortgages. Yet it's still a relatively small number of institutions and individuals getting hurt by this not-yet-a-recession. So what's the worst that could happen?

Sorry we asked.

A number of economists and banking industry experts believe the subprime crisis could metamorphose into the biggest debacle to hit the sector since the savings and loan catastrophe of the 1980s, which caused some $500 billion in losses to the banking industry. And that means the future of a couple of name-brand financial institutions could be in jeopardy.

Much will depend on how far home prices tumble over the next few quarters, how high unemployment climbs, how many homeowners are pushed into foreclosure from rate resets, and, most importantly, how far the crisis spills into the conventional mortgage market and other parts of the credit sector. "The impact here could be far larger [than the S&L crisis] in terms of the dollar amount and the spillover effects into other parts of the economy, particularly the consumer," said Merrill Lynch economist Kathy Bostjancic.

Why? Home prices fell about 6% in 2007 and are expected to tumble another 15% in 2008, 10% in 2009 and 5% in 2010, said Bostjancic. Unemployment, which climbed to its highest level in two years in December at 5%, will hit 5.8% by year end and 6% in 2009, predicts Bostjancic. As this happens, she said, the crunch will likely expand into prime mortgages, home equity loans and credit cards, making it the worst consumer recession since 1980. The buildup of credit was "unprecedented" and is now unwinding, she said.

The Bush Administration's rate-freeze program for certain subprime homeowners and the recently passed stimulus/rebate package, along with the Federal Reserve's aggressive rate cuts, offer short-term fixes. But it won't stop the carnage. "The principal concern of the current credit crisis lies in the possibility that banks will eventually run out of capital," said Doug Duncan, chief economist with the Mortgage Bankers Association, in his updated 2008 forecast.

Many believe the government will ultimately step in with a housing industry bailout to the tune of hundreds of billions of dollars before it would allow a major bank to collapse.

Subprime horror stories have been making headlines for much of the past year as falling home prices, a pullback in housing demand, overbuilding, interest rate resets, growing defaults and tightening lending standards played havoc in the residential market. A flurry of mortgage companies, including American Home Mortgage Investment Corp., New Century Financial Corp. and Delta Financial Corp., filed for Chapter 11 bankruptcy protection.

Big banks took large write-downs, and chief executives from three of them — Citigroup's Charles Prince, Bear Stearns' James Cayne and Merrill Lynch's Stanley O'Neil — resigned. Citigroup and Merrill Lynch shook the market when Citigroup posted an $18.1 billion write-down, $9.8 billion loss, and 41% dividend cut, and Merrill Lynch posted its largest loss in the firm's 94-year history in the fourth quarter. Both warned of more write-downs ahead. "Who would have guessed the banks would have incurred the losses they've incurred already, especially on triple A investments," said Chip MacDonald, partner in the Atlanta office of Jones Day.

Experts fear this is just the tip of the iceberg. There are $1 trillion in outstanding subprime mortgages, with potential losses estimated at about $250 billion, said Bose George, an equity analyst with Keefe, Bruyette & Woods Inc. Columbia University professor Charles Calomiris pegs the losses even higher — at between $300 and $400 billion.

All of this comes as a large wave of ARM and hybrid mortgages are poised to reset this year — an event that could push the crisis into the conventional mortgage and credit markets. Once this happens, "it's almost impossible to imagine any bank or financial institution going unscathed and I would be very surprised if at least some aren't threatened," said Dean Baker, co-director of the Center for Economic and Policy Research, a Washington think tank. He believes the losses will easily exceed that of the S&L debacle.

Subprime borrowers, who had eye-poppingly low teaser rates of 7% to 8%, will see rates jump as high as 11% when they reset. Even conventional borrowers with ARM and hybrid mortgages could face a crunch, especially those who stretched their finances to buy a home, those who took advantage of loose lending standards by taking out big loans without showing documented proof they could afford it, and those whose home values have plummeted below the mortgage amount.

Merrill Lynch's Bostjancic said the biggest impact of rate resets, from a dollar perspective, will come in the third quarter of 2008. She sees losses from all loan defaults exceeding $500 billion in 2008.

There are already signs the turmoil is creeping into the conventional mortgage market and other credit areas. Indeed, 5.6% of all loans were at least 30 days overdue in the third quarter — the highest rate in 20 years , according to the Mortgage Bankers Association. Mark Greene, chief executive of credit analysis firm Fair Isaac Corp., warns that "losses on prime mortgages can easily be two to three times what they were on subprime mortgages." Delinquencies are also ticking up among credit cards and home equity loans, said Dennis Moroney, an analyst with TowerGroup Research.

"It kind of reminds me of the old cartoon of the little Dutch boy with his finger in the dyke, and while he's trying to plug up the subprime hole, there are leaks sprouting all around him," said Mark Fitzgibbon, director of equity research at Sandler O'Neill & Partners. "Subprime is just one small piece of of it."

Bostjancic said the credit crunch is already affecting consumer spending as U.S. retailers experienced the worst holiday sales season since 2001, and consumer confidence hit its lowest level in 20 years. "The amount of debt that's likely to go bad is virtually certain to be in the high hundreds of billions of dollars, and it wouldn't surprise me if it ends up crossing a trillion," said Baker.

Steve Persky, managing partner and chief executive of Dalton Investments LLC, believes the federal government would step in with a heavy-handed bailout before allowing a major bank to blow up. "I don't think the Fed will let a major bank fail," he said.

Still, some industry analysts and investors see opportunity in the beaten-down financial stocks and battered mortgage-backed securities market. "There are double-A and triple-A subprime-backed securities that have a 25% or 30% collateral cushion below them that are trading at 50 cents on the dollar," Persky said. "This presents one of the best distressed opportunities I've seen in years."

Sharon Haas, managing director of Fitch Ratings, admits investors "started to panic" and randomly slashed values on virtually all mortgage-backed securities, even those that aren't at risk. "The market just doesn't know how to value those securities," she said. It had better learn soon, or the price of that education will become astronomical.