How will the slow motion collapse of the $1.3 trillion subprime mortgage industry affect the rest of the economy? I believe that the subprime mortgage collapse could contribute to widespread credit losses among companies that provide short-term funding to the subprime lenders and among the pension funds, insurance companies, and hedge funds that hold the securities backed by the growing pile of bad loans. These losses will lead to tighter lending standards which will make capital scarcer and contribute to a credit crunch which could crimp economic growth.

I think that the subprime problems will not remain isolated solely to subprime borrowers and lenders for seven reasons:

• Big, complicated and difficult to understand financial instruments could surprise institutions. The subprime loans have been sliced and packaged into collateralized debt obligations (CDOs) which now represent a substantial portion of the $7 trillion mortgage-backed securities (MBS) market -- according to SeekingAlpha, 81%, or $202 billion, of 2005's $249 billion in CDO pools consisted of residential mortgage products -- which are currently in the portfolios of institutional investors such as insurance companies, hedge funds, and pension funds -- particularly in Europe and Asia. According to the Wall Street Journal [subscription required] MBS pioneer Lewis Ranieri is worried that due to a lack of transparency, neither he nor these investors fully understand the risks of their CDOs to themselves and to the global economy.
• Forced buy back of bad loans could hurt subprime mortgage capital suppliers. CDO owners are exercising their rights to force the subprime mortgage originators to buy back bad loans in their portfolios which is causing many such originators to file for bankruptcy -- thus defaulting on their loans to providers of wholesale funding. This is what forced ResMae into bankruptcy on February 13th.

• Institutional flight to quality will steepen inverted yield curve. CDO owners are increasingly likely to sell their securities as the perceived risk of default rises -- for example, an index of credit-default swaps on 20 subprime mortgage bonds with the lowest investment-grade ratings sold in the second half of last year dropped to a record low for a sixth straight day, according to Bloomberg. These CDO sellers are investing the proceeds in less risky securities -- such as 10-year treasury notes -- which is driving the 10 year rate further below shorter-term interest rates.
• Banks will assume greater risk to offset dwindling lending profits. This steepening inverted yield curve could cause a problem for banks who traditionally make money by taking in deposits at a low short-term rate and lending those deposits out a higher long-term rate. When short term rates are higher than long term ones, banks can't make money in the traditional way. Instead the banks take on greater risk -- whether in the derivatives market or in hedge funds -- in order to offset the lower lending profits. If these riskier derivatives or hedge fund investments stumble -- generating larger than anticipated losses -- banks' capital could be eroded.
• High debt levels mean economy is sensitive to Fed's inflation control. If short term rates rise due to the Fed's efforts to tame inflation, the risk rises of default on higher credit quality adjustable rate borrowing including prime mortgages, stock margin account debt -- which at $286 billion has surpassed the previous 2000 record, and perhaps even leveraged buyout loans -- which hit a record $480 billion in 2006 -- Moody's forecasts they'll double their default rate to 3.07% by the end of 2007.
• Credit losses could lead to tighter lending standards and lower collateral values. For example, subprime delinquencies hit 12.6% in the last quarter of 2006, up from 11.7%. This could lead to rising bankruptcies and foreclosures -- e.g., the Center for Responsible Lending estimates that 2.2 million subprime borrowers will lose their homes, bigger loan charge-offs at banks, distress selling of homes, and much tighter lending standards. For example, while too late to stop the current flood of bad loans, such standards are tightening already -- loans for 100% of a property's value required a minimum credit score of 580 in 2006, but now require at least a 600 score. Moreover, the Wall Street Journal [subscription required] noted that Credit Suisse expects subprime mortgage losses to total $10 billion in the next two years. These losses will further reduce the amount of capital available to lend.
• Economic slowdown could follow. These trends will slow down economic growth and cause corporations to cut costs by closing plants and laying off employees. While tighter lending standards may be good in the long run, in an economy where the savings rate is -0.5% and two-thirds of GDP growth depends on consumers, economic growth is limited by consumer's ability to take on more debt. This morning, Bloomberg reports that the housing slump -- spurred by these foreclosures -- may lead the US to lower its 2007 growth forecast.

With 47% of subprime loans lacking documentation of the borrower's income, the odds are very strong that many of those loans will not be repaid. The rising tide of housing prices -- boosted by an undisciplined flood of credit -- was able to defer the day of reckoning.

But sooner than many think, we will be paying the price for betting that it would be different this time.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, He also teaches management at Babson College and edits The Cohan Letter.