So what has become of all those subprime mortgages, sold to over-consuming SUV-driving Joe Soccer mom, Jose` day laborer, and Susie Q. welfare queen -- re-packaged, securitized, and sold to (other) banks through the mortgage market? What happens when these loans start to turn up bad, like bodies in the East River?

Ruth Simon and Michael Hudson of the WSJ shine some light on this question:

A generation ago, nobody asked. Banks made loans and suffered the consequences when borrowers didn't pay. Today, a complex Wall Street machine buys and sells mortgages and packages the loans into securities that are diced and sliced and sold again to investors world-wide. [Ed. note: as well as the same set of banks that originated them.]

Although the $9.1 trillion mortgage market has been relatively calm as the housing market has slowed, players on Wall Street and beyond are starting to grapple over bad loans, especially in the market for borrowers with scuffed credit -- so-called subprime customers.

Under contracts that govern the exchange of mortgages, lenders often must take back loans that default very early in their lives or that come with underwriting mistakes, such as flawed property appraisals. As the housing boom fizzles, cases of bad underwriting are popping up and more mortgages are defaulting early. That has investment banks and other mortgage buyers invoking these contract provisions and pressing lenders to repurchase mortgages that get sold to third parties, creating big losses for some lenders.

In response, some of the loan originators are tightening their underwriting standards. Investors and lenders also are doing more financial sleuthing to sniff out problems in loans. [Ed. note: like they should have been doing in the first place.]

H&R Block Inc. recorded a $131 million loss for the quarter ending July 31, largely because it added $102 million to reserves for loans its unit Option One Mortgage Corp. had to repurchase. In August, Fremont General Corp. of Santa Monica, Calif., said it was dropping or scaling back on some low-down-payment loans and on some loans to subprime customers to reduce mortgage buybacks. Bear Stearns Cos. and other companies are suing lenders that they claim passed on bad mortgages that quickly defaulted.

This is indeed getting ugly. So we're just warming up with defaults, and companies like H&R block are already having $100 million dollar write-downs.

Some idea of the present and potential scale of these problems:

Mortgage repurchases aren't always reported, so it is unclear how many loans are being sent back to their lenders, or their total value. A study by Credit Suisse Group found evidence of a jump in the subprime market. It examined 208 bond deals involving pools of subprime mortgages totaling $234 billion. The study found nearly half of these mortgage pools had some loans repurchased in the first quarter of 2006, up from less than a third that faced repurchases in 2005. The dollar value of repurchased mortgages has been small -- well under 1 percent of the total value of mortgages in the pools with at least one repurchase -- but it also climbed, the study found.

As per usual, anything having to do with risk in the system lives almost entirely in the feel-good realm of "fuzzy accounting." Thus far, that hasn't bothered anyone. I have a sneaking suspicion that era is coming to an end, as the Credit Suisse study suggests.

There's more informative data:

Of the $3.1 trillion in mortgages originated last year, 68 percent were packaged into securities, Bear Stearns said. In the past, most mortgages rolled into securities were standard loans packaged by government-chartered loan clearinghouses Fannie Mae and Freddie Mac. Investment banks increasingly have gotten in on the action, and they have helped fuel the growth of atypical mortgages, including risky ones that don't require down payments or income documentation.

"You had a well-oiled machine," said Thomas Lawler, a former Fannie Mae economist and now a consultant. As loan volume declined in 2005, lenders got "a little more creative" and loan quality declined. [Ed. note: So we've heard.]

Credit Suisse estimates early defaults more than doubled on subprime loans that didn't require income documentation between the first quarter of 2004 and the first quarter of 2006.

Boy, those worry-warts at Credit Suisse just won't stop with the bad news, will they?!

It looks like the biggest boys in the Wall Street pool are involved:

In a lawsuit in U.S. District Court in Dallas, Bear Stearns's EMC Mortgage Corp. unit is suing MortgageIT Holdings Inc., New York, in an attempt to force it to buy back at least 587 loans totaling $70 million. The lawsuit alleges MortgageIT failed to repurchase defaulted loans, as required by sales contracts. MortgageIT, which is being acquired by Deutsche Bank AG, denies the allegations in court papers and vowed in a securities filing that it will "vigorously defend" itself. Representatives for Bear Stearns and MortgageIT declined to comment.

Bear Stearns vs. Deutsche Bank! Cool!! Its like an investment banking cage match.

The following questions regarding this mortgage lending situation are worth pondering:

1. How much worse could these buybacks and defaults get?
2. If they increase, what happens to the profitability of the originators?
3. What happens to their stocks?
4. What happens to their solvency?
5. If their solvency is threatened, what happens to the solvency of the banks and other financial institutions who were buyers of the securitized mortgages?
6. What happens to their stocks?
7. What happens to their solvency?

Some hints might lie in the following observations about general economic trends:

1. Subprime lending has been high, and even increasing (just a few months ago mortgage originators were pledging to make up for reduced volume by increasing subprime lending)
2. American consumers are more extended than they ever have been in history (the extent of negative savings proves this).
3. Interest rates can only go up.
4. Housing prices are starting to head down.
5. There is already not much home equity left to extract.
6. The Fed and co. have released new, stricter lending standards.
7. Inflation is on the rise.
8. Wages are stagnant.

What can I say? This seems like the perfect storm.