Mortgage meltdown contagion

NEW YORK (CNNMoney.com) -- The outlook for the housing market looks even bleaker than it did a week ago. Last Friday we reported that foreclosures were skyrocketing, home prices falling and recovery forecasts were being scaled back.

And now this week, the mortgage meltdown spread to the financial markets with ebola-like speed, sparking fears that tighter credit will have a broader impact on consumers, markets and the economy.

The U.S. government continues to downplay the danger. When the Federal Reserve met this week, the central bank said that inflation is the greatest threat to the economy, not the mortgage crisis.

Yet, Countrywide Financial, the nation's largest mortgage lender by volume, reported Thursday that "unprecedented disruptions" in the mortgage market were forcing it to cut way back on the number of loans it was securitizing and selling in the secondary markets.

In the financial markets, credit, including corporate bonds, has become harder to get. Mark Zandi, chief economist of Moody's Economy.com, had been loath to call it a "credit crunch." Instead, he called it a "liquidity squeeze," that had spread to corporate bond and other financial markets. The difference: In a crunch, nobody can get a loan; in a squeeze, only the riskier borrowers are cut out.

"I think it's still a liquidity squeeze," Zandi now says, "but it has elements of a credit crunch, affecting much of the mortgage market."

It has yet to severely disrupt the prime loan market, however, according to Zandi. The situation will continue until financial institutions revalue their mortgage-backed securities to what they're actually worth.

"They're faced with redemptions and margin calls, and they have to value their securities to their market prices because they have to sell them," said Zandi. That will determine how hard a hit the investment community will take.

Peter Schiff, president of Euro Pacific Capital Inc. and author of "Crash Proof: How to Profit from the Coming Economic Collapse," has said the problem goes way beyond subprime.

"It's a mortgage problem," he said. "Subprime is like a little leak where the underlying problem is the integrity of the dam itself. Most of the mortgages taken out during the past few years will fail."

Schiff expects huge losses in the housing market with home prices falling by half in some areas, which he said has to affect the overall economy. He said he'd been expecting the financial markets to start taking hits long before this week's drop.

"This week is making more sense," he said. "The economy is a basket case."

Most economists are nowhere near as pessimistic. Standard and Poor's chief economist, David Wyss, and Moody's Economy.com's chief economist, Mark Zandi, have forecast 8 percent price drops in the housing market, peak to trough.

Zandi does not believe a consumer spending slowdown is enough to trigger a recession, but he hasn't counted it out. What it will do, he said, is "ensure that the economy grows at a pace below its potential. I wouldn't dismiss the possibility of a recession. I put the possibility at one in five."

Ken Goldstein, an economist for the Conference Board, has said he doesn't believe the subprime contagion is enough to send the economy off-track, and that "the idea that average consumers are quaking over the prospects of losing their homes or much of their equity is wrong."

Your Home: When to cash out

The mortgage market adds up to about $10 trillion, according to Goldstein, with about 10 percent to 15 percent of that in subprime. Of that, some 15 percent or so is imperiled, he said.

"It's big, but not the tipping point that will bring the whole housing market down."

But on Friday Goldstein did concede that "The panic and concern over credit is even spreading across the pond to European markets."

On Friday the European Central Bank (ECB) pumped extra cash into the system for a second day in a row, as a means of calming nervous traders. The ECB added $83 billion in liquidity Friday.

The Federal Reserve followed suit, adding $19 billion in temporary reserves. The move was the biggest single temporary open market operation in four years, the New York Federal Reserve said, according to Reuters.

Subprime problems have not, so far, slowed consumption down much. The pace of consumer spending is still brisk, although growth slowed in June. And the Conference Board reported last week that consumer confidence is at a six-year high. Steady job growth and low unemployment (between 4.4 percent and 4.6 percent since September) have kept it that way.

Consumers don't really care much about changes in housing prices or, for that matter, in the stock market, according to Goldstein.

"If you really want to screw up consumer confidence," he said, "go for the jugular - the labor market."

Said Mark Sirinyan of Ineo Capital, an alternative-asset advisory firm, "I don't think there will be a recession because of private equity or the credit markets alone. There are lots of other reasons it could happen - we're fighting a war and spending money."

And according to Schiff, "What [the optimists] don't realize is that consumer spending has been a function of easy credit and the high housing market. The idea that Americans will keep spending is wrong. With [lower home equity and less access to credit] where're they going to get the money?"

Steven Cesinger, chief financial officer for Dewberry Capital, said, "People think liquidity will carry us forward. I've been in financial markets for 25 years and i've seen that the faucet can turn off as rapidly as it turns on."

According to Goldstein, though, as long as employment stays strong and workers' earnings grow substantially (4 percent annually, according to him), confidence - and spending - will remain high and the economy will chug along.

"Consumers can continue to stay resilient in the face of lower stock and home prices," he said. "Not only is the economy strong enough to survive the crisis, it's strong enough to quiet it."