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A few days ago, Gretchen Morgenson of the NYTimes wrote one of the most comprehensive articles on the looming (or already here) mortgage crisis that could spell trouble for the economy. We've already seen the DOW fall almost 600 points from the highs of a few weeks ago, and all eyes are on defaulting mortgages, particularly in the sub-prime mortgage market. Are we watching another bubble burst as we speak?

On March 1, a Wall Street analyst at Bear Stearns wrote a surprisingly upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks.

What happened next seems all too familiar to investors who bought technology stocks in 2000 at the breathless urging of Wall Street analysts. Last week, New Century said it would stop making loans and needed emergency financing to survive. The stock collapsed to $3.21.

The analyst's untimely call, coupled with a failure among other Wall Street institutions to identify problems in the home mortgage market, isn't the only familiar ring to investors who watched the technology stock bubble burst precisely seven years ago.

Now, as then, Wall Street firms and entrepreneurs made fortunes issuing questionable securities, in this case pools of home loans taken out by risky borrowers. Now, as then, bullish stock and credit analysts for some of those same Wall Street firms, which profited in the underwriting and rating of those investments, lulled investors with upbeat pronouncements even as loan defaults ballooned. Now, as then, regulators stood by as the mania churned, fed by lax standards and anything-goes lending.

And then there's this:

Already, more than two dozen mortgage lenders have failed or closed their doors, and shares of big companies in the mortgage industry have declined significantly. Delinquencies on loans made to less creditworthy borrowers - known as subprime mortgages -recently reached 12.6 percent. Some banks have reported rising problems among borrowers that were deemed more creditworthy as well.

Traders and investors who watch this world say the major participants - Wall Street firms, credit rating agencies, lenders and investors - are holding their collective breath and hoping that the spring season for home sales will reinstate what had been a go-go market for mortgage securities. Many Wall Street firms saw their own stock prices decline over their exposure to the turmoil.

"I guess we are a bit surprised at how fast this has unraveled," said Tom Zimmerman, head of asset-backed securities research at UBS, in a recent conference call with investors.

A big part of the problem is that it's very hard to figure out who has assumed the risk for many of these mortgages that are going bad, since the development of derivatives has just masked, or diluted, the risk inherent in these loans. Additionally, since the value of these mortgages are based on the ratings given them by the big ratings agencies (Moody's, S&P, etc), if these agencies are not downgrading them properly, then their value remains artificially high. For instance,

Accounting conventions in mortgage securities require an investor to mark his holdings to market only when they get downgraded. So investors may be assigning higher values to their positions than they would receive if they had to go into the market and find a buyer. That delays the reckoning, some analysts say.

Furthermore:

Some investors wonder whether the rating agencies have the stomach to downgrade these securities because of the selling stampede that would follow. Many mortgage buyers cannot hold securities that are rated below investment grade - insurance companies are an example. So if the securities were downgraded, forced selling would ensue, further pressuring an already beleaguered market.

Finally,

A paper published last month (.pdf) by Mr. Rosner and Joseph R. Mason, an associate professor of finance at Drexel University's LeBow College of Business, assessed the potential problems associated with disruptions in the mortgage securities market. They wrote: "Decreased funding for residential mortgage-backed securities could set off a downward spiral in credit availability that can deprive individuals of home ownership and substantially hurt the U.S. economy."

The Economist and Investment Dealer's Digest have been covering this important story, too. Make sure you understand what might be coming down the pike!

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