The seemingly small news that Fremont General Corp., was no longer issuing piggyback second mortgage loans gave Jim Bagley a breath-stealing, punch-in-the-gut feeling. And the punches kept coming as the sub-prime mortgage lending market continued to crumble, dragging down with it other once-ubiquitous exotic loan products and bringing all in danger of extinction.

"The backlog," Park Square Homes' president bemoaned. Scrubbed free of those early 2005 sales that went south when the market turned, this news threatened the thinner, harder-won list of new orders. Some of those buyers likely won't be able to close on their homes now under construction because they won't qualify for a mortgage under the stiffer lending requirements coming down the pike. But how many?

And what about future sales? Tighter lending standards are likely to cause a headwind for those as well. It would be difficult to cut home prices enough to make the deals work, builders say.

"You know [lending standards] are going to get tighter," Bagley says. "And you know it's going to be a flight to quality. What does that mean? We don't have any numbers yet."

As the mortgage market news got beaker, builders combed through their backlogs, attempting to assess just how many existing sales could be in peril. Some called buyers to prepare them for the possibility that they might need to qualify for a different mortgage product than they intended getting, perhaps one requiring a higher down payment. At the same time, builders started looking more closely at the deals they are selling now, making sure buyers can qualify for the loans under stricter standards before starting the houses.

"If we don't get better underwriting at the point of sale, I am signing up and building a home for someone who can't close," Bagley says.

David K. Hill, chairman of Kimball Hill Homes, says his company also started reviewing its backlog in early March to ascertain what percentage was sub-prime and what part would be challenged by some of the new regulatory suggestions. Less than 5 percent of the builder's backlog was sub-prime.

"That's not too surprising," Hill says. "We have been watching this problem for two months at least and have been managing it down. ? Also the numbers of Alt-A loans are sharply down in my portfolio."

He says other big builders have done the same thing in recent weeks, cutting their risk of losing backlog sales. "Right now, it's the sudden 'oh my God' period in mid-March," says Hill. "This is bad, but it's not the end of the world."

Similar backlog assessments by other big builders also were encouraging, says Samuel L. Hill, managing director and regional head of Calyon, Credit Agricole's corporate and investment bank. Calyon provides short-term "warehouse" loans to builders' finance companies and also repackages those loans to resell them to open-market investors.

At a recent Calyon conference, builders made assurances that their exposure was small. "Most of our builders don't provide sub-prime loans and most don't hold mortgages," Calyon's Hill says. However, he acknowledges credit tightening will cause further pressure on the already faltering new-home sales market.

"There is no doubt that anytime you have credit tightening up at any end of the chain you are going to have a ripple effect," he says. "There is no doubt that what is going on in this sector is once again going to slow down the sales in the industry."

How much is difficult to assess, partly because it isn't clear yet how much credit tightening will happen and what types of loans it will affect.

Mike Fratantoni, senior economist for the Mortgage Bankers Association, does not think a true credit crunch is imminent. Sure, lenders are adjusting loan products to reflect the increased risk of mortgages, but mortgage lending isn't going to stop.

"The analogy that I'm using is that we used to have a light switch, where mortgage credit was either on or off," says Fratantoni. "Now we have installed a dimmer. ? There is one caveat."

If federal regulators get involved with the credit tightening process rather than letting the market digest the extra risk by creating products to reflect it, there could be more dramatic brakes put on lending. "We are trying to caution them that that is not the right action right now," he says.

There's something else that could put the brakes on the lending market–the possibility that, in the face of higher delinquency and default rates, mortgage-backed securities will fall out of favor with investors.

A recent study by Joshua Rosner, an associate professor of finance and research fellow at Drexel University, and Joseph R. Mason, managing director of Graham Fisher & Co., shows that more risk may be baked into the mortgage-backed securities issued in the past few years than investors know. Many have at least some sub-prime and exotic loans that have a much greater tendency to default in a falling market.

"Our findings imply that even investment grade rated CDOs [collateralized debt obligations] will experience significant losses if home prices depreciate," the study says.

–Teresa Burney

Learn more about markets featured in this article: Miami, FL.