Subprime Meltdown - How widespread is it?

I've been having an ongoing discussion of the mortgage market with a client of mine (Bill) for some time now. I thought our latest series of e-mails were very interesting so I thought I would post them here for your comments.

Yesterday Bill wrote, "Don, It seems the big banks have pretty heavy exposure to the debt they enabled. Economic rule number one is when there's easy money to be made, pigs will wallow in mud and in this case their own excrement as Merrill has done. They say humans and pigs share 97% of the same genes. Too bad the 3% aren't all the undesirable ones. Human greed is reliable, and it is always the setup for the crisis. Let's see how bad this gets. I was relying on this aspect of human nature in my assessment of the crisis that is unfolding. It looks bad from everything I read."

I responded with, " There's no question that Merrill made some bad business decisions. I do find it interesting the brokerage houses such as Merrill are now regularly being identified as banks, but that's a different issue. As bad as Merrill played the market, Goldman represents the other end of the spectrum; look at today's Times. Every so often you read about some investor or hedge fund looking at buying heavily discounted securities and/or insolvent mortgage companies. The market is bad right now and it may get worse before it gets better but there is a lot of money sitting on the sidelines positioned to take advantage of buying opportunities. We can't lose sight of the fact that the high foreclosure rate in the subprime arena represents a small percentage of the mortgages in the MBS market. The entire world of MBS has suffered in price yet the majority of the mortgages in the pool are performing. It's only a matter of time before the investor community takes advantage of this."

"I agree with what you say that it's probably a small percentage, but other stories also indicate that people overextending themselves straddled all income classes. Let's agree that the nonperforming percentage is small, the accelerant is the amount of leverage that was taken on by the holders of those assets. When the stock market crashed in 2000, the investors that used leverage to purchase securities exacerbated the natural downturn. That's why the hedge funds are blowing up over this. Then you have Merrill that did what Lucent did during the .com craze, they funded their own sales. Chaos theory says that small events when they weave themselves through a system, have profound effects on the overall system. I tend to believe in that science, and currently there's a lot of evidence supporting that position. I have been reading about Goldman Sachs, but think about if a second. If they only concluded the problem was small, they wouldn't have taken the contrarian position and they wouldn't be so exemplary. It's the fact that the problem is bigger than everyone thought makes them so uncommon because they had good acumen when others didn't." - Bill

I ended the day with, "Yes, people overextending themselves throughout all income classes. You need to look at 2 things. First, the number of people overextended is relatively small compared to the total population of homeowners. Then secondly, not everyone that is currently overextended is going to go into default. For example, someone who is temporarily unemployed is overextended but living off of saving or additional borrowing. He will work his way through this situation without going into default.
It's not a good comparison when you compare housing to the stock market. Stocks can be bought or sold on a phone call, there is mob psychology as well as panic thinking that influences the market moment to moment. The housing market operates on a much longer timeline and current market value is not something you can open to a newspaper section and get today's price on your home. This creates a buffering effect that forces people to cool down before reacting.
This is both a positive as well as a negative but in the end, you don't see the equity of your home moving up and down on a daily basis as you see your stock portfolio move. We're not even considering the fact that your home serves the duel purpose of a shelter as well as an investment, something that does play an important role.
I don't think Goldman realized the magnitude of the decision they made. The impression I got from the article was that they made a business decision that the risk outweighed the reward when looking at MBS and they invested accordingly. In hindsight the risk proved to be substantially larger that they anticipated. Instead of making a prudent business decision it turned out to be a brilliant business decision.
There is no question things are not good in this economy. The question is how bad is the economy and how large an influence has the housing market had. There is a layering of influences going on and housing is just one of them. It's a long list: oil prices, the Iraq war, the trade deficit, the ongoing cost of terrorism, etc. When you begin to identify all the ongoing issues you can't help coming to the conclusion that it's amazing the economy is as healthy as it is.
This housing problem is going to nowhere near the magnitude of the dot com collapse. It's just not that far reaching."

What's your opinion? We all see events differently. By sharing our views we can each develop a better viewpoint and therefore be better equipped to make decisions.