For hundreds of thousands of Americans, it is a personal financial disaster. For the wider US economy, it is a growing economic shock with an increasing potential to inflict severe repercussions on the nation’s prospects and prosperity.

The deepening scandal of the US “sub-prime” mortgage implosion looks more and more like a cautionary tale of financial excess that sits unhappily alongside Enron and the dot-com bubble, both in terms of scale and consequences.

It is story of Dickensian bleakness: of avaricious money-merchants and of the broken dreams of struggling but foolhardy men and women who seized on false promises of an easy leg up the ladder of their own aspirations.

To much of the United States, and most of us in Britain, “sub-prime” lending is another country of which we know little. Yet for millions of America’s poor, it is a financial trend that has turned from seeming salvation to curse in five or six short years.

Viewed in hindsight, the debacle that is now unfolding was, like many such events, an obvious accident waiting to happen.

Around the turn of the decade, as the US housing boom accelerated, a large group of greedy American lending institutions became so rashly intent on maintaining the growth of their loan books at all costs that they began to hand out mortgages to borrowers with varying combinations of poor credit history, no steady source of income and little or no collateral.

As lending criteria grew more and more relaxed, the risks associated with this reckless “sub-prime” lending escalated, with vulnerable borrowers being given access to loans for 100 per cent of property values and high multiples of their incomes. And, just as soaring house prices meant that more people had to resort to such sub-prime loans, so sub-prime lending itself gave more fuel to the property boom.

Two factors turned this trend into a train wreck. First, the vast bulk of sub-prime loans were adjustable rate mortgages, or “Arms”. While these start out at enticing, discounted rates, interest payments jump when such inducements expire.

Now payments on many of these loans are being reset, at a time when official US interest rates are much higher, having been lifted from historic lows of 1 per cent in 2003 and 2004 to more than 5 per cent now.

The result is that borrowers cannot meet repayments, so that mortgage arrears and defaults on sub-prime loans are surging. In turn, more than 30 mortgage lenders have shut up shop since last year. For borrowers and lenders, this was an Arms race on a road to financial destruction.

The second factor makes the picture still worse. For many sub-prime borrowers, these financial horrors have been compounded by seeing their repayments leap just as the US housing market boom hit the buffers. Tens of thousands who were already struggling to service their loans had resorted to refinancing, taking on still more debt at disadvantageous terms. But with falling house prices in some areas now pushing these overstretched people into negative equity, the lenders’ doors are barred. Repossessions and forced sales of homes are rising sharply.

It is plain that the social consequences of all of this are as grim as they are scandalous. Yet many US analysts appear excessively relaxed about the wider fallout for a slowing American economy, arguing that the scale of the sub-prime market means that any spillover effects will be slight.

This looks about as complacent as the thoughtless lenders who are now going to the wall. Not only is it clear that the sub-prime crisis is going to get a whole lot worse before it runs its course, but the potential for a domino effect hitting large parts of the United States’s housing market, and the wider economy, looks rather greater.

The sub-prime market mushroomed over the past five years, so that by last year it accounted for almost a quarter of new mortgages, worth about $665 billion. That’s up from 10 per cent of loans, worth some $200 billion, in 2001.

Analysis by Paul Dales, of Capital Economics, notes that the percentage of sub-prime mortgages now in persistent arrears has climbed to more than 13 per cent, from 10.3 per cent at the end of 2004, while default rates have risen to 4.5 per cent of sub-prime loans. As Mr Dales suggests, arrears and defaults are likely to climb more steeply, as many sub-prime mortgages have yet to reset to higher interest-rate levels. And the problems will almost certainly be compounded by weakening economic conditions, as well as falling house prices in some regions that will push more borrowers into the trap of negative equity.

The threat of wider, knock-on consequences will then escalate if forced auctions of repossessed homes drive up the supply of houses for sale just as housing demand is curtailed both by a faltering economy and (inevitably) the greatly reduced availability of sub-prime loans.

An excess of property and a drop in demand will put more downward pressure on US house prices, deepening the slump in the property market. In turn, the impact could then be felt on consumer demand, since American homeowners have for years relied on cashing in on the previously rising value of their homes to finance their high-spending habits.

Sanguine observers believe that the sub-prime market is too small to have such a big impact. But Capital’s analysis highlights a detailed study by the US Centre for Responsible Lending which estimates that 20 per cent of sub-prime mortgages made in the past two years could end in defaults — meaning an extra 600,000 US homes could be put up for sale: a rise of 15 per cent compared with the total size of the market in January.

Factoring in lower demand, in the event of sub-prime loans completely drying up, Mr Dales calculates that — in a possible worst-case scenario — the sub-prime meltdown could end up with ten months’ supply of homes on the US property market, up from about six months’ supply now: enough to trigger significant price drops.

Even if things do not get quite this bad, what is increasingly clear is that the parable of the sub-prime lender is not one that will have a happy ending.

gary.duncan@thetimes.co.uk

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