Losses on bad US mortgages are barely one-third through...

The U.S. HOUSING BUBBLE was one for the ages. We've all heard stories of one kind or another, writes Chris Mayer of the Capital & Crisis newsletter.

There was the glass cutter who earned $5,000 per month, pretax. WaMu gave him a $615,000 home loan with payments of $3,600 per month.

There was a house – a shack, really – that appraised for $132,000 and got a mortgage of $103,000. The owner hadn't worked in 13 years. Upon foreclosure, a neighbor bought the house and paid $18,000 just to tear the thing down.

America, it seems, just went crazy – borrowers, lenders, nearly everybody. These anecdotes and others are told in a new book titled More Mortgage Meltdown by money managers Whitney Tilson and Glenn Tongue.

But what caused the mania and how we got there is less to the point than what happens from here. Even so, the stories are amazing...

"If the problems in the mortgage market were limited to subprime loans, then the carnage would be mostly behind us," the authors note. Subprime loans were the riskiest mortgage loans. Prime loans. By contrast, were made to borrowers who made a substantial down payment and had good credit history.

The subprime borrowers were the first to fail...but they certainly will not be the last. The nearby chart shows the other mortgage markets, most of which are only now beginning to show signs of distress.

The first thing to jump out at you is that subprime is only about a $1.5 trillion market - not anywhere near the biggest of the risky loan categories. There are other layers here.

Subprime is only one slice of low-grade bologna. It sits at the bottom. Alt-A is the next riskiest slice of mortgages above subprime. Alt-A are mortgages to people who are better credit risks than subprime, but still not prime. Documentation is still spotty as far as verifying income, and loan-to-value ratios are high. Plus, about a quarter of these mortgages went to non-owner-occupied homes - which were subject to even greater speculation.

The scary thing is that this mortgage market is 150% bigger than subprime. Unlike subprime, Alt-A loans typically have five-year resets - meaning, the interest rates adjust to higher rates. The Alt-A reset surge doesn't really get started until 2010! It continues through 2012.

You'll also see something called "option ARMs" on that chart. Even though the option Arm market is much smaller than the subprime market, it is also much riskier. An “option ARM” is a loan that allows the borrower to pay less than the total amount due from month to month. Whatever amount the borrower does not pay is added to the total loan amount...up to a pre-determined limit.

Obviously, loans like these are very easy to satisfy initially, but can become difficult or impossible if the borrower has been making token payments for a long time. What’s worse, these loans usually offered ultra-low teaser rates at inception, then re-set to higher fixed rates later on. The reset surge for these loans only starts in 2010.

You'll also see something called "jumbo prime" on this chart. These are big loans, on average about $750,000. These were common in the most inflated bubble states, such as California and Florida, and were often made to poor credit risks. This is a market of some $1.5 trillion – about as big as subprime.

Then there are home equity lines, which you'll see just below jumbo prime. In calendar 2007, Tilson and Tongue explain, home equity lines funded "30% of new car purchases in California and 20% in Florida." These loans are second loans, behind all the garbage I mentioned above. That means that many home equity loans will be a total loss for the lenders, as housing prices have collapsed and can't even support the junk loans in first position, much less junior liens like home equity lines.

I won't go into all of these loan categories, but I think you get the picture. All together, these “other” loan categories total more than $5 trillion – or more than three times sub-prime. Even worse, issuance peaked during the peak bubble years of 2005, 2006 and 2007.

Moreover, the pattern for all of these loans was the same. You see rapid growth in the bubble years, roughly from 2000-2007.

Through March of 2009, banks had taken only $1.1 trillion in write-downs to date. Even the most conservative estimates put total credit losses at $2.2 trillion. Tilson and Tongue make a convincing case that the losses will be far worse than that, more like $3.8 trillion. And these numbers seem only to grow over time.

I remember sitting at a Grant's conference over a year ago when John Paulson, the fund manager who saw all this coming and profited mightily, tossed out $1 trillion as the number for total losses. That number induced gasps at the time. So I think Tilson and Tongue will be closer to the mark. It may well be even more than that when it is all said and done.

The fallout from all of this is that the banks will have to raise a lot more capital. They've raised only $1 trillion so far - yes, “only.” Given the high leverage in the banking sector, they may yet need to raise at least another $1 trillion. I don't see how that is possible in today's market. Where is the money going to come from?

The margin for error is extremely small.

As banks' assets got riskier - with subprime, Alt-A and all the rest – the banks actually borrowed more to hold these assets. The typical bank has only 4 cents of tangible equity for every dollar of assets. That means a 4% drop in asset value wipes out the equity - making the bank insolvent. The banking system is vastly undercapitalized. Throughout the 1990s, banks operated on leverage of about 16-to-1. Today, they operate on 25-to-one leverage...or higher!

And this, then, answers the great fundamental question that seems to baffle so many market commentators. Why aren't the banks lending? People point to the trillions of dollars the government pumped into the economy, including on bank balance sheets.

The answer is that the bankers know they will need the money to cover losses from their toxic loan portfolios. The banks are clearly not lending. Banks are cutting lines of credit to consumers - and to businesses, too. New loans in various business categories are down 60-80% from where they were a year ago.

It is hard to imagine any economic recovery when the banking system has such gaping funding holes it needs to fill. As it is, banks are failing and the losses are severe - on average, the losses amount to more than 40% of assets. The data coming in on foreclosure recoveries are bleak. In California, recovery is often less than 35 cents on the dollar., which means a loss of 65 cents on the dollar. It's not supposed to happen like this. If this crisis is anything like previous cycles, we've got a long way to go on bank failures.

How do we invest in this environment? For starters, continue to avoid banks and leveraged financial institutions in general. And don't expect the banks to start lending so freely again anytime soon. That means you should also avoid businesses that depend on regular access to credit to grow - such as real estate investment trusts. I would also say that the housing market is not due for any recovery anytime soon. There is still enormous inventory to work through. So homebuilding stocks and related investments also face stiff head winds.

At the right price, I might buy almost anything else. But investing is hard enough without also taking on problems as big as the ones I've outlined here. There are plenty of other great places to fish. Continue to avoid the financials.