We expect more bank meltdowns as the subprime mortgage mess continues to play out. By Andrew Tanzer, Senior Associate Editor March 14, 2008 JP Morgan's bailout for Bear Stearns became more permanent late in the day March 16, when the bank announced it was buying the ailing brokerage for $2 a share. The government quickly approved the deal to avert Bear's bankruptcy and prevent panic overseas before financial markets opened in Asia.Bear Stearns' stock (symbol BSC) has shed 80% of its value since last summer, when the credit markets erupted. We wish we could say that this will be an isolated case of investment-bank insolvency. True, Bear Stearns dined out on subprime mortgage-backed securities, the epicenter of the financial earthquake, and so was particularly vulnerable to the collapse of this exotic, Wall Street-created market. But we expect more bank insolvencies and severe distress in the banking system as the housing bubble deflates. The problem begins on the asset side of the balance sheet with crumbling housing prices. Housing prices have fallen more than 10% since they peaked in mid-2006, erasing about $2.5 trillion of household wealth, says Desmond Lachman of American Enterprise Institute. He notes that the rate of decline accelerated in the fourth quarter of 2007 to an annualized rate of 20% and projects that prices will fall another 10% to 15% this year. Advertisement House prices are still hugely overvalued relative to household incomes, Lachman says. New homebuilding is in a free fall, inventories of unsold homes and home-vacancy rates remain at record highs and foreclosures are soaring. It's a nasty stew. So regardless of the Fed's interest-rate cuts and the government's fiscal stimulus, housing prices appear to be headed lower. Now let's look on the liability and equity side of the balance sheet. A few months ago Jan Hatzius, economist at Goldman Sachs, estimated that bank losses from mortgage securities would reach $400 billion, which could precipitate a $2 trillion contraction in bank lending in the economy. Banks, after all, are heavily leveraged businesses. Hatzius recently raised his estimate of bank losses on mortgages to $500 billion. This doesn't include growing losses on leveraged loans, high-yield securities, construction companies and other markets increasingly in distress. The losses could induce a $3 trillion contraction in credit, which would clearly harm the economy. But that raises another problem for the banks and the housing market: They're stuck in a vicious cycle, or "adverse feedback loop," as economists like to call it. As home prices fall and losses mount on mortgage securities, the banks boost write-offs, which reduces their equity and lending ability. So they tighten lending standards and shrink their loan books -- de-leveraging -- which helps to force down housing prices. Advertisement Finally, we get to the complex derivatives, such as collateralized debt obligations, that banks hold on or off balance sheets. Bob Rodriguez of FPA Capital fund notes in his shareholder letter that vastly more debt has been created outside the banking system this decade, such as through mortgage securitizations, than through the banks. Nominally banks are one of the most tightly regulated industries, with strict rules for capital ratios. Yet banks have strangely been permitted to value structured financial instruments in seemingly arbitrary ways. The banks say they "mark to model" when they value these instruments for which there often is no liquid market. Rodriguez writes: "I refer to 'marking to model' as 'Imaginary Accounting.' You imagine a price and then you account for it at that price. Many of these securities values are predicated on valuation models that were created by management. This is like having the fox guard the hen house." We don't know how or when the unraveling of the banking system will end. Until it does, the stock market will be held captive (the Dow Jones industrial average fell almost 200 points on March 14). Advertisement The recapitalization will unfortunately require more capital injections from our overseas friends in the Persian Gulf, China and elsewhere. And it's hard to imagine a solution without heavy U.S. government intervention. John Makin, an economist at American Enterprise Institute, thinks the choice will be "to monetize or nationalize" -- that is, to inflate the economy or take over the banking system. Neither choice sounds too appetizing.