Subprime woes: How far, how wide?

NEW YORK (CNNMoney.com) -- Lending to homeowners and buyers without good credit has suddenly become a very bad business - and possibly a very big problem for the U.S. economy as a whole.

The sector is known as subprime mortgages, which pumped $640 billion into the economy through facilitating home purchases and refinancings in 2006, according to trade publication Inside B&C Lending. That's nearly twice the level of this kind of lending seen as recently as 2003.

But now, with delinquencies and defaults by borrowers rising, experts in the field see more lenders filing for bankruptcy and a sharp pullback in subprime lending. In addition, banking regulators are proposing tougher lending standards and regulations in the sector. All that sent shares of some major financial firms sharply lower Monday.

"Everyone in the subprime sector this year is going to lose money," said Bose George, analyst with Keefe, Bruyette & Woods, a Wall Street firm specializing in banking and finance. "They're getting squeezed on all sides. Going into the year, we were looking for a decline of 15 percent [in subprime lending], but clearly now that is far too low. It's now looking like a 25 to 30 [percent] decline."

On Wall Street, the biggest loser Monday was New Century Financial (Charts), the No. 2 subprime lender according to Inside B&C Lending. Its shares plunged nearly 70 percent in midafternoon trading Monday after the company said in a filing late Friday that it was facing a criminal probe of its practices by the Justice Department and that its outside auditor, KPMG, said it now believed there was substantial doubt about New Century's ability to function as a going concern.

But other lenders in the sector also got hit. For example, Fremont General Corp. (Charts) lost a third of its value after it announced it would exit the subprime sector because of the demands of regulators and market conditions.

While it's the smaller subprime lenders whose shares have taken a beating, many of the nation's biggest financial services firms are also leading subprime lenders.

Some economists say that choking off more than $100 billion in home financing will cause problems for real estate and home prices overall by keeping some buyers out of the market and by forcing some current homeowners to sell or face foreclosure.

"People who a year ago could have purchased a house with a subprime mortgage aren't going to be able to purchase," said Paul Kasriel, chief economist with Northern Trust in Chicago. "Increased foreclosures will mean more inventory on a market that already has a glut of homes for sale."

Kasriel said the additional hit to real estate from the subprime meltdown is likely to mean serious problems for the economy overall.

"Housing has played a very large role in this expansion and one of the reasons it's played that role is there has been a change in the mortgage market," he said. "This has been a credit-induced housing boom that lifted other sectors of the economy and it's all in reverse now."

One watchdog group, the Center for Responsible Lending, forecast recently that 19 percent of subprime mortgages originated during the past two years will end in foreclosure.

"This rate ... exceeds the worst foreclosure experience in the modern mortgage market, which occurred during the 'Oil Patch' disaster of the 1980s," the group said in a report issued in December.

The group praised a call from federal regulators Friday for much tougher standards for lenders making subprime loans. But the tougher standards will mean many borrowers will be cut off from financing, according to requests for public comment on the proposal.

The proposed new rules come after mortgage financing firm Freddie Mac (Charts) said it would no longer buy subprime loans on the secondary market that have a high likelihood of excessive payment shock and possible foreclosure. Freddie Mac's new guidelines, and the proposed federal rules, would require that a borrower qualify at the highest rate possible under adjustable-rate loans, a move that would leave many not able to qualify.

The proposed rules on new standards and the action by Freddie Mac are important since most subprime lenders package their loans into securities to sell in the secondary market in order to get additional funds to make further loans.

In the new, tougher financing environment for subprime lenders, ACC Capital Holdings, the closely held owner of Ameriquest, the No. 7 subprime lender, said last week it secured additional working capital from Citigroup (Charts). In return, Citi got an option to buy ACC's wholesale mortgage business as well as its mortgage servicing operations. CitiMortgage is already the nation's No. 4 subprime lender.

"This relationship is a result of ACC Capital Holding's thorough review of the current market and the different strategic alternatives currently available to an independent mortgage lender," it said in a statement.

Citi is not the only major financial services firm in the subprime sector. Last Thursday, Countrywide Financial (Charts), one of the nation's largest mortgage lenders, warned that 19 percent of the nonprime loans it collects payments for are delinquent. Its shares slid another 3 percent Monday on concerns about the sector.

Other leaders in subprime mortgage lending in the United States are units of some of the nation's biggest financial services firms, including HSBC (Charts), the No. 1 subprime lender, which took a $10.6 billion charge for bad loans, as well as General Electric (Charts), Wells Fargo (Charts) and Washington Mutual (Charts).

And some businesses that aren't generally thought of as subprime mortgage lenders, such as H&R Block (Charts) and General Motors (Charts), also have subsidiaries in that business.

One cause of GM's delay in reporting fourth-quarter results is the attempt to look at how changes in the real estate loan market affect the value of GMAC, the financing subsidiary that GM sold a 51 percent stake in during the quarter.

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