Making Sense of the Mortgage Mess

Defaults are soaring and stocks are tanking. But it's no time for alarm

by Mara Der Hovanesian, Peter Coy and Matthew Goldstein

When General Motors' (GM) 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 (NFI), Accredited Home Lenders (LEND), 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%.

"Limited Impact"

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 (MHP). 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 (FAF), 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.

Resilient Economy?

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.

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 (FRE). 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.