New Century’s disclosure of the federal investigations on Friday was the most serious in a string of shocks to have rocked the industry in the last three months.

A handful of lenders have sought bankruptcy protection, several have been acquired and a few have been shut down. Also on Friday, Fremont General, a top-five lender, said it planned to leave the business.

Industry officials say they are seeing an exodus of executives and salespeople as companies fold, cut jobs and push out early leaders.

“Everyone has run for the hills,” said William D. Dallas, whose company, Ownit Mortgage, filed for bankruptcy protection in December after it lost financing from Merrill Lynch and other banks.

For the borrowers of these mortgages, it may become more difficult to refinance if lending standards are tightened significantly. Many are already facing the prospect of payment shock when low, fixed-interest mortgage rates adjust to higher, variable rates.

On Wall Street, big investment banks could lose a significant source of revenue if the appetite for bonds backed by mortgages dries up.

In the last two years many skeptics began warning that the red-hot housing market and adjustable-rate loans would blend into a toxic brew. Last year, subprime loans totaled $600 billion, or about 20 percent of all mortgages, up from $120 billion and 5 percent in 2001, according to Inside Mortgage Finance. More than half of subprime loans have adjustable rates.

Many of the problems that have surfaced thus far are not tied to the resetting of rates. Rather, they stem from a sharp and early spike in the default rates among loans issued last year.

For example, about 13.8 percent of the loans in a group of mortgages New Century sold to investors in April were behind in payments or in foreclosure by January. By comparison, only 6 percent of loans in a pool sold to investors in March 2005 had met that same fate by January 2006.

Investors and regulators fear that the problems will only worsen as so many borrowers have fallen behind so quickly, especially at a time when the overall economy is healthy. The phenomenon suggests that lending standards were significantly weakened last year and that lenders were not as watchful for fraudulent transactions.

For New Century, the early payment defaults pose significant financial problems. In the first nine months of last year, Wall Street banks and investors that it does business with forced it to buy back $469 million in loans it had sold to them, up from $240 million for the same period in 2005.

The company was able to sell back about half of those loans at a discount of 26.5 percent. How it handled the remainder — about $227 million — is now under scrutiny. According to accounting rules the company should have valued the loans on its books for what they were worth today, not their previous face value. But it did not.

If it had, the company would have seen its earnings fall by about $60 million before taxes, wiping out most of its profit in the third quarter, according to Zach Gast, an analyst at the Center for Financial Research and Analysis, a forensic accounting firm.

This is important, because the company’s financing agreements require that it not lose money for any rolling six-month period. On Friday, New Century said it did not expect to make a profit in the six months that ended in December and that it was negotiating with lenders to waive the requirement but has only secured six of 11 waivers it needs.

“They had losses sitting on their balance sheets,” Mr. Gast said.

In August, the company’s chief financial officer, Patti M. Dodge, announced she was stepping down from her post to oversee investor relations, a department that typically reports to the chief financial officer. Taj S. Bindra, a former executive at Washington Mutual, replaced her in November.

For the second time in a decade, New Century finds itself fighting to survive. The firm’s roots were planted at Plaza Home Mortgage Bank where the three founders of New Century — Mr. Cole, a longtime mortgage executive; Mr. Gotschall; and a lawyer named Bradley A. Morrice — worked together. The three formed New Century in 1995 after Plaza was sold to Fleet Mortgage Group, now a part of Washington Mutual.

In the late 1990s, New Century narrowly survived accounting concerns and a scare in the bond market after Russia’ s default in 1998. It pulled through thanks to an investment by U.S. Bancorp, a bank based in Minneapolis.

With interest rates at historic lows, it quickly grabbed a big share of the fast-growing subprime market during the housing boom.

“They walked into a niche industry at a time when everything was lining up perfectly for what they did,” said W. Scott Simon, a managing director at Pimco Advisors. “In 2001, 2002 and 2003 the subprime business was just phenomenally profitable. Home prices kept appreciating and it seemed that no loans ever went bad.”

In appearances he makes for clients, his contracts stipulate that no reporters may be admitted and no recordings made. He said he tries to have an exchange with an audience, in which he often learns something that helps him hone skills he has worked on for 50 years.

"I was aware of the problem that if I stayed public, I could make it difficult for Ben," he said. "For the most part it has worked. I was beginning to feel quite comfortable that I was fully back to the anonymity I was seeking.

"I was surprised at this recent episode," he said.

Investors may have taken notice of his comments on Feb. 26 in Hong Kong because they considered them prescient. The day after he mentioned the risk of a recession, a Commerce Department report showed sales of nonmilitary capital goods, excluding aircraft, dropped 2.7 percent in January, the biggest decline since September 2001. Orders slumped by the most in three years.

Broader capital spending is also weakening. Corporate purchases of equipment and software declined at an annual rate of 3.2 percent last quarter, the biggest decline since the final three months of 2002, according to Commerce Department figures.

Greenspan said he did not think that so-called point forecasts, in which economists refine their projections down to decimal points, could be accurate in the near term. "We really can't forecast" the economy over the next two years, he said.

Greenspan worked for what is now the Conference Board, a New York business group, as an industrial-metals analyst from 1950 to 1953. Tracking inventories, he was able to come up with a model of final demand. He expanded that model to textiles, aluminum and oil.

He found that large-scale models that used aggregate data averaged out the nuances and changes he could pick up at an industry level. Finally, some of the assumptions of firms' pricing power didn't hold up.

"I realized I was trying to see how the world works in the context of individual entities," Greenspan said.

Under his chairmanship, the Fed staff began surveying companies directly on how their businesses were doing.

"We certainly devoted some resources to our own gathering of anecdotal information," said Michael J. Prell, former head of the Division of Research and Statistics, the Fed's central forecasting unit. "Every other week, we would contact some subset of a sizable group of firms."

Greenspan's unique discipline both frustrated and amazed Fed colleagues, especially those trained in sophisticated economic modeling.

"His great value is that he has an idiosyncratic approach," said Laurence H. Meyer, a Fed governor from 1996 to 2002 who often sparred with the chairman over the outlook. "The reason why Greenspan gets and deserves disproportionate weight is that he doesn't get caught up in all the themes that tie together in a consensus forecast. He is looking at all the different strands of data."

Once, Meyer said, he was sitting in a meeting with the Fed staff discussing the inflation implications of import prices. Out of nowhere, Greenspan asked about steel-ingot prices. Meyer said he wasn't even sure what an ingot was.

"Why would I ever even ask that?" Meyer, a founder and vice chairman of the model-based forecasting firm Macroeconomic Advisers in St. Louis, said in an interview.

Macroeconomic Advisers isn't forecasting a recession this year, and Meyer said markets "over-responded" to what Greenspan said.

"Who wouldn't agree that it is possible we could have a recession?" Meyer said. "I think we are closer to the middle of an expansion than the end of an expansion."

Now, full disclosure is important in any business. The more both parties know -- in this case, the lender and the borrower - - the more informed decisions they can make.

Fraudulent practices or misrepresenting the terms of a loan undermine the soundness of the financial system.

But where was it written that a lender should dispense with normal due diligence -- verification of income and assets -- before extending credit to a deadbeat to finance 100 percent of the purchase price of a house? Does that qualify as best practices suggested by both federal and state regulators, or in the best interest of either party if the borrower doesn't have the ability to repay the loan?

``Credit scoring has had a dynamic impact on lending,'' says Steve Fritts, associate director of risk management policy at the FDIC in Washington. ``It's a proxy for capacity and character,'' two of the three ``C's'' of credit (the third is collateral). ``But it's a limited proxy'' compared with the in- depth financial analysis and verification of a full underwriting, he says.

In Rerun

The widening cracks in the home-loan market aren't solely the fault of lenders.

``Investors were irrationally exuberant'' at the same time ``lenders and brokers were given incentives -- a big pay package -- to get customers into subprime loans,'' says Andy LaPerriere, a managing director at the ISI Group in Washington.

``Innovation may have made it easier to mislead,'' he says. ``But the key driver was the willingness on the part of lenders and mortgage purchasers to take on high risk, which will turn out to be a big mistake.''

And low interest rates created artificial (read: speculative) demand.

During a bubble, be it in the stock market or real estate prices, we want the government to stay out of the way. The bust produces finger-pointing, congressional hearings and new regulations.

Playing to Constituents

Congressional committee chairmen have already invoked the idea of ``predatory lending'' to create interest in planned hearings. Both Barney Frank, Massachusetts Democrat and chairman of the House Financial Services Committee, and Christopher Dodd, Connecticut Democrat and chairman of the Senate Banking Committee, want to ensure that borrowers have adequate protection.

In an opening statement at a Feb. 7 hearing, Dodd said ``that predatory and irresponsible lending practices are creating a crisis for millions of American homeowners.'' The Reverend Jesse Jackson testified, which is guaranteed to make the issue about race.

This may buy votes, but it misses the point. There is enough irresponsibility to go around on the part of both lenders and borrowers. As the bodies float to the surface, shady lending practices become obvious.

But predatory?

Senator Richard Durbin, the No. 2 Senate Democratic leader, said he is open to the idea of helping subprime borrowers while noting that Democratic leaders haven't decided whether to do so.

``We have not discussed it, but that doesn't mean that we can't or shouldn't,'' Durbin said in an interview. ``Senator Dodd is in a key position on the Banking Committee and he's talked to us about the scope of this problem and what the reasonable response might be. I'm sensitive to it. There's nothing worse than a person losing their home.''

Durbin said that Democratic leaders will look to Dodd for recommendations as Dodd's committee examines the issue.

New Bill

Representative Barney Frank, a Democrat from Massachusetts and chairman of the House Financial Services Committee, reiterated today that he intends to introduce a bill to deter lenders from offering consumers mortgages they can't afford.

``We plan to legislate to restrict those kinds of mortgages going forward,'' Frank said after a hearing in Washington. He declined to elaborate on the timing or details of such legislation.

Dodd reaffirmed a plan to introduce a bill that would combat predatory lending. ``There is a difference between a subprime lender and a predator, and I don't want to lose the subprime lender,'' he said.

The Federal Reserve, Federal Deposit Insurance Corp and other U.S. regulators on March 2 directed banks to scrutinize underwriting standards, provide more information to customers about borrowing risks and ensure borrowers are able to repay loans.

``Finally the federal regulators are beginning to indicate that they want to start requiring similar standards to be used for prime and subprime lending,'' Dodd said, referring to the new guidelines.

The spillover mechanism is hardly complex. Asset-dependent economies go to excess because they generate a burst of domestic demand that outstrips the underlying support of income generation. In the absence of rapid asset appreciation and the wealth effects they spawn, the demand overhang needs to be marked to market. The spillover is a principal characteristic of such a post-bubble shakeout. Interestingly enough, in the current situation, spillovers have first become evident in business capital spending, as underscored by outright declines in shipments of nondefense capital goods in four of the past five months. The combination of the housing recession and a sharp slowdown in capex has pushed overall GDP growth down to a 2% annual rate over the past three quarters ending 1Q07 – well below the 3.7% average gains over the previous three years. Yet this slowdown has occurred in the face of ongoing resilience in consumer demand; real personal consumption growth is still averaging 3.2% over the three quarters ending 1Q07 – only a modest downshift from the astonishing 3.7% growth trend of the past decade.

Therein lies the risk. To the extent the US economy is now flirting with “growth recession” territory – a sub-2% GDP trajectory – while consumer demand remains brisk, a pullback in personal consumption could well be the proverbial straw that breaks this camel’s back. The case for a consumer spillover is compelling, in my view. A chronic shortfall of labor income generation sets the stage – real private compensation remains over $400 billion below the trajectory of the typical business cycle expansion. At the same time, reflecting the asset-dependent mindset of the American consumer, debt and debt service obligations have surged to all-time highs whereas the income-based saving rate has dipped into negative territory for two years in a row – the first such occurrence since the early 1930s. Equity extraction from rapidly rising residential property values has squared this circle – more than tripling as a share of disposable personal income from 2.5% in 2002 to 8.5% at its peak in 2005. The bursting of the housing bubble has all but eliminated that important prop to US consumer demand. The equity-extraction effect is now going the other way – having already unwound one-third of the run-up of the past four years. In my view, that puts the income-short, saving-short, overly-indebted American consumer now very much at risk – bringing into play the biggest spillover of them all for an asset-dependent US economy. February’s surprisingly weak retail sales report – notwithstanding ever-present weather-related distortions – may well be a hint of what lies ahead.

It didn’t have to be this way. Were it not for a serious policy blunder by America’s central bank, I suspect the US economy could have been much more successful in avoiding the perils of a multi-bubble syndrome. Former Fed Chairman Alan Greenspan crossed the line, in my view, by encouraging reckless behavior in the midst of each of the last two asset bubbles. In early 2000, while NASDAQ was cresting toward 5000, he was unabashed in his enthusiastic endorsement of a once-in-a-generation increase in productivity growth that he argued justified seemingly lofty valuations of equity markets. This was tantamount to a green light for market speculators and legions of individual investors at just the point when the equity bubble was nearing its end. And then only four years later, he did it again – this time directing his counsel at the players of the property bubble. In early 2004, he urged homeowners to shift from fixed to floating rate mortgages, and in early 2005, he extolled the virtues of sub-prime borrowing – the extension of credit to unworthy borrowers. Far from the heartless central banker that is supposed to “take the punchbowl away just when the party is getting good,” Alan Greenspan turned into an unabashed cheerleader for the excesses of an increasingly asset-dependent US economy. I fear history will not judge the Maestro’s legacy kindly. And now he’s reinventing himself as a forecaster. Figure that!

Greenspan or not, downside risks are building in the US economy. The sub-prime carnage is getting all the headlines these days, but in the end, I suspect it will be only a footnote in yet another post-bubble shakeout. America got into this mess by first succumbing to the siren song of an equity bubble (see my 25 April 2005 dispatch, “Original Sin”). Fearful of a Japan-like outcome, the Federal Reserve was quick to ease aggressively in order to contain the downside. The excess liquidity that was then injected into the system after the bursting of the equity bubble set the markets up for a series of other bubbles – especially residential property, emerging markets, high-yield corporate credit, and mortgages. Meanwhile, the yen carry trade added high-octane fuel to the levered play in risky assets, and the income-based saving shortfall of America’s asset-dependent economy resulted in the mother of all current account deficits. No one in their right mind ever though this mess was sustainable – barring, of course, the fringe “new paradigmers” who always seem to show up at bubble time. It was just a question of when, and under what conditions, it would end.

Is the Great Unraveling finally at hand? It’s hard to tell. As bubble begets bubble, the asset-dependent character of the US economy has become more deeply entrenched. A similar self-reinforcing mechanism is at work in driving a still US-centric global economy. Lacking in autonomous support from private consumption, the rest of the world would be lost without the asset-dependent American consumer. All this takes us to a rather disturbing bi-modal endgame – the bursting of the proverbial Big Bubble that brings the whole house of cards down or the inflation of yet another bubble to buy more time.

The exit strategy is painfully simple: Ultimately, it is up to Ben Bernanke – and whether he has both the wisdom and the courage to break the daisy chain of the “Greenspan put.” If he doesn’t, I am convinced that this liquidity-driven era of excesses and imbalances will ultimately go down in history as the outgrowth of a huge failure for modern-day central banking.

The housing sector will push the U.S. economy into recession unless the Federal Reserve cuts its benchmark rate at the first surge in unemployment, said Kiesel, who expects the Fed to reduce rates.

Home Equity Loans

In addition to their primary mortgages, homeowners had $913.7 billion of debt in home equity loans in 2005, more than double the $445.1 billion in 2001, according to a paper by former Federal Reserve Chairman Alan Greenspan and James Kennedy on equity extraction issued by the Fed three months ago.

About a third of that money, extracted as home values surged 53 percent from 2000 to 2005, was used to buy cars and other consumer goods, according to the paper. The interest rate on those loans doubled to 8.25 percent in 2006 from 4 percent in 2003.

If the Federal Reserve lowers the rate it charges for overnight lending to banks, that would cut the prime rate that moves in tandem with it and reduce the interest on many types of adjustable home loans, including home equity mortgages.

Federal Reserve policy makers probably will keep the overnight bank lending rate unchanged at a six-year high of 5.25 percent when they next meet on June 27, according to a Bloomberg survey of 72 economists.

Boom and Bust

Homebuyers who got an adjustable-rate mortgage, a so-called ARM, in 2004 have seen their rate climb by about 40 percent. That's enough to add $288 to the monthly payment for a $300,000 mortgage. The average adjustable rate last week was 5.75 percent, an 11-month high, according to Freddie Mac.

Roubini predicts the decline in U.S. home sales will last at least another 12 months, reducing the median house price by 5 percent this year and next. That would take home prices back to 2004, when the national median was $195,200.

The primary cause of the 1990 to 1991 recession was a real estate boom and bust similar to the past seven years, Roubini said. A real estate ``bubble'' in the mid-1980s led to speculative buying and lower credit standards that resulted in widespread foreclosures, he said. The defaults triggered a credit crunch that turned into an economic recession in the spring of 1990, said Roubini, who is an economics professor at New York University's Stern School of Business.

He put the chance of a recession this year at ``50-50,'' above former Fed chief Greenspan's 33 percent estimate. A recession is a decline in gross domestic product for two consecutive quarters.

`Significant Drag'

Greenspan warned of ``froth'' in the real estate market in 2005, before leaving the central bank in January 2006. Three months ago Greenspan said there was a ``one-third probability'' of an economic recession this year, in large part due to the unsteady housing market. He reiterated that view last month at a conference hosted by Merrill Lynch & Co. in Singapore

``There is no doubt there is a slowdown going on in the U.S.,'' Greenspan said at the conference. ``We are clearly having troubles in the capital investment area, as well as potentially in the consumption area and obviously housing being a significant drag.''

A Fed survey of senior loan officers issued in April said that 45 percent of lenders had restricted ``nontraditional'' lending, such as interest-only mortgages, and 15 percent had tightened standards for the most creditworthy, or prime, borrowers. More than half had raised standards for subprime borrowers, according to the survey.

Subprime mortgages have rates that are at least 2 or 3 percentage points above the safest so-called prime loans. Such loans made up about a fifth of all new mortgages last year, according to the Mortgage Bankers Association in Washington.

Housing Chain

Making it harder for those people to buy houses is going to create trouble all the way up the housing chain as people who own starter homes find it more difficult to sell their real estate and buy bigger properties, said Neal Soss, chief economist at Credit Suisse Holdings USA Inc. in New York.

``The subprime market has changed character dramatically, and that takes a number of entry-level buyers out of the picture,'' said Soss, who was an adviser to former Fed Chairman Paul Volcker.

Home sales won't increase in any sustained way until 2008, though the stumble probably won't cause a recession because the housing market hasn't reduced consumer spending, he said.

Retail Sales Endure

``Here we are a year and a half into the housing slowdown and retail sales are off the chart,'' Soss said. The economy expanded at a 1.9 percent pace in the first quarter, compared with a year earlier, the smallest gain since the 1.8 percent rate in the second quarter of 2003, ``but it hasn't collapsed, and I don't think it will,'' he said.

Bank of America Corp. Chief Executive Officer Kenneth Lewis yesterday said the U.S. housing slump is almost over. ``The drag stops in the next few months,'' said Lewis, whose bank relies on the U.S. market for almost 90 percent of its revenue. ``We do not see a recession. Because that drag stops, you'll see the economy begin to pick up in the third and fourth quarters.''

Median Home Price

The median U.S. price for a previously owned home fell 1.4 percent in the first quarter from a year earlier, the third consecutive decline, according to the National Association of Realtors. Before the third quarter of 2006 prices hadn't dropped since 1993. The quarterly median may dip another 2.4 percent in the current period, the Chicago-based industry trade group said in its June forecast.

Measured annually, the national median price for a previously owned home hasn't dropped since the Great Depression in the 1930s, according to Lawrence Yun, an economist with the trade group. This year it probably will fall 1.3 percent, Yun said.

The share of mortgages entering foreclosure rose to 0.58 percent in the first quarter, the highest on record, from 0.54 percent in the final three months of 2006, the Mortgage Bankers Association said in a report last week. Subprime loans going into default rose to a five-year high of 2.43 percent, up from 2 percent, and late payments from borrowers with poor credit histories rose to almost 13.8 percent, the highest since 2002.

Prime loans entering foreclosure increased to 0.25 percent, the highest in a survey that goes back to 1972. That's a sign that even the most creditworthy borrowers are being squeezed, Roubini said.

Adjustable Rates

``We have a lot of people, even prime borrowers, who are at the edge because they either bought with no equity, they have an ARM that's seen a rate spike, or they used their house like an ATM and turned their equity into cash,'' Roubini said. ``Many of those people are under water today, and if they have to sell, it's going to drag down values in their neighborhood.''

Some owners are selling their homes at ``fire sale'' prices to avoid foreclosure after seeing their adjustable mortgage rates spike, said Lawrence White, an economics professor at the Stern School of Business.

``Prices will continue to soften for as long as we have distressed sellers,'' White said. Some regions of the U.S. could see price declines of 10 percent in the next six to 12 months, he said. The slump probably won't cause a recession, he said.

``It's not going to be the 1929 stock-market disaster, with people jumping out of buildings, but there is going to be widely dispersed pain for the next few quarters,'' he said.

The biggest problem is volatile home prices, said Gary Shilling, head of A. Gary Shilling & Co., an economic forecasting company in Springfield, New Jersey. Shilling put the chance of a recession this year at 75 percent.

`Exploding ARMs'

``A lot of people went out on a limb to pay the record high prices for homes, and they're in trouble now,'' he said.

Borrowers who got loans with so-called teaser rates are in the biggest bind, according to Shilling. Prices surged a record 12 percent in 2005, spurring buyers to ``stretch'' to qualify for bigger loans by using interest-only ARMs or so-called option ARMs with low introductory payments.

Some have payments based on interest rates as low as 1 percent. At the end of an introductory period, the rate can more than quadruple, leading them to be called ``exploding ARMs,'' he said. Some loans allow borrowers to choose how much they want to pay, with the balance added to the loan's principal, making it possible to owe more than the home's purchase price.

``Homeowners with adjustable-rate mortgages are getting squeezed on all sides,'' said Diane Swonk, chief economist at Mesirow Financial Inc. in Chicago. Real estate taxes have surged along with home prices, and many U.S. homeowners saw their property insurance double after Hurricane Katrina ravaged Louisiana and Mississippi, she said.

Swonk said the housing slide will last into next year. Still, she doesn't expect the economy to slow because of it.

``The economy could easily beat expectations in the second half of this year,'' she said. ``The housing correction remains the primary threat to that happening.''

To contact the reporter on this story: Kathleen M. Howley in Boston at.....