(This is Part 1 of a two-part series. Read Part 2, “Subprime relief plan’s major flaw.”)

The financial crisis we are currently in will probably enter the U.S. record book as the second worst in the last 100 years. The worst was in the early 1930s when thousands of banks failed and the mortgage market shut down entirely. It has not shut down this time, thanks in large part to federal institutions created during the ’30s to deal with that crisis.

The housing finance system is really two overlapping systems that exist side by side. One system consists of portfolio lenders, mostly depository institutions, which hold the mortgage loans they originate. The portfolio system was the larger part of housing finance prior to the savings-and-loan crisis of the 1980s, but gradually lost ground thereafter.

The other system consists of temporary lenders who either sell loans in the secondary market to firms that securitize them or resell to still other firms that securitize them. Securitization means placing mortgages in a pool and issuing mortgage-backed securities (MBS) against the pool. This secondary market system began in the early 1970s and grew at the expense of the portfolio system — until the recent crisis.

The crisis originated in the subprime segment of the secondary market system, and quickly spread. The crux of the crisis is a loss of confidence by the investors who purchase MBS, and their retreat to the sidelines. When investors stop buying, the secondary market system grinds to a halt.

One part of the secondary market system, however, has continued to function more or less normally. This is the “conforming loan” market, which covers loans no larger than $417,000 that meet the eligibility requirements of Fannie Mae and Freddie Mac. Investors have retained their confidence in the two federal agencies, which they assume would be supported by the federal government if that became necessary. Hence, they continue to purchase the MBS issued and insured by the agencies.

The crisis has also reenergized the portfolio system. Portfolio lenders have raised additional funds from channels unaffected by the crisis: by selling certificates of deposit, which are insured by the Federal Deposit Insurance Corp., and by borrowing record-breaking amounts from the Federal Home Loan Bank system. The banks raise money by selling bonds, and like Fannie and Freddie, they continue to enjoy the confidence of investors.

Portfolio lenders have been turning more often to mortgage insurance, both from FHA and from private mortgage insurers. FHA had shrunk markedly during 2000-2006 as the subprime market expanded, while private mortgage insurance had been negatively impacted by lender self-insurance in the form of second mortgage “piggybacks.” Both trends have been reversed.

Four of the five federal agencies now supporting the market were created during the financial crisis of the 1930s. The only exception is Freddie Mac, which was formed in 1970. If not for these institutions, the current crisis would be much worse.

But it is bad enough. Portfolio lenders have replaced only part of the shortfall left by temporary lenders deserted by investors. The portfolio lenders live in the same world as secondary market investors, see the same frightening data on foreclosures, and have tightened their underwriting requirements across the board. Further, many are constrained by capital requirements, especially those who participated in the secondary market system as investors and have suffered capital losses.

The upshot is that, just as many loans were made during 2005 and 2006 that should not have been made, today there are loans that should be made that aren’t. Further, the prices of all deviations from underwriting perfection contain a “fright premium,” and are therefore priced higher than they ought to be. This is true even in the conforming market, where Fannie and Freddie have raised the price increments on borrowers with less-than-excellent credit.

How Long Will It Last?

This semiparalyzed market will continue until investor confidence is restored. Key players are the investment banks and hedge funds who sold MBS when prices were high in expectation that they could buy them back later at lower prices. At some point they must go into the market to cover their short positions. They will do that when they decide that MBS prices have reached a bottom.

That will not happen before we see the end of unpleasant surprises — large value write-downs by major U.S. firms, or revelations by some previously unknown foreign institution in trouble because they too bought subprime-contaminated securities. Most firms come clean at year-end, so hopefully the surprises will stop then.

Once the surprises stop, the shorts will look for a bottom in house prices and a peak in foreclosures. When both become clear, they will make their move.

Next week: What is needed for recovery, and how much help will the relief plan provide?

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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