How Bad Can It (the Subprime Meltdown) Get?

Implications: Banking, mortgage, capital markets and other industry participants are comparing the current “subprime” mortgage market meltdown to the U.S. Savings and Loan crises whose roots were caused by archaic deposit and loan regulations and nurtured under the Reagan administration’s hands off regulatory watch in the early 1980s. This latter crises cost the U.S. taxpayer over $125 billion by the time the bailout was authorized in 1991. How long will the current crisis last? Will Countrywide and other high volume subprime lenders survive? Will political initiatives from the Bush administration or Congress make a difference?

Analysis: Scarcely a day goes by without another dose of bad news from a large financial institution. Almost all the big firms have admitted to higher loan loss provisions and/or writing down the value of mortgage backed securities. In spite of the staggering amounts, upwards of $10 billion/institution in some cases, it can get worse. Cause and effect linkages will be a drag on the mortgage and housing markets longer than many expect.

1. Financial instrument innovators expanded the secondary mortgage market product offerings with customized features available through securitized instruments. In search of higher yielding instruments for some investors, the origination market players created new mortgage products, loosened the underwriting standards, and turned up the volume. Some bank holding companies tried the old spread-carry trade game with off balance sheet SIVs. The result: we are in new territory as the market decline unfolds.

2. Mortgage loan volumes peaked between 2003 and 2005. Originations dropped in 2006 as a much larger share of the volume was due to expanding subprime mortgage volume. Origination volumes are still falling as new home sales, existing home resales and refinancing of existing mortgages are all still declining. The result: unprecedented volumes of poorly underwritten mortgages will lead to an extended series of losses.

3 .Past housing and mortgage credit declines/recessions have lasted several years. Political initiatives will not shorten this cycle or eliminate losses. Resolving problem mortgages embedded in the massive volume of securitized mortgage backed securities adds time, cost and uncertainty (who gets the money?) to the recovery process. The result: the universe of problem mortgages will likely exceed 2 million mortgages, either through foreclosure or seriously delinquent mortgages. Each case will have to be resolved one at a time, defying a quick, politically driven, fix. Some local/regional markets will take longer than three years to recover (meaning 2010 or later).

4. The mortgage servicing firms are facing a higher cost structure, lower collectible servicing fees, and lower levels for new mortgage related fees. The result: all three factors contribute to a serious drag on profits. Countrywide Financial (CFC), Washington Mutual (WM), and IndyMac Bank (IMB) are large originators/servicers that are trapped by the market turbulence. Subprime servicing firms and Mortgage REITs may not survive at all.