THE UNSUSTAINABLE HOUSING BOOM THAT began in the latter part of 2003 and ran into the early part of 2006 was fueled by extraordinarily stimulative financial market conditions, including a historically low interest rate structure in the U.S. We also saw a progressive relaxation of mortgage lending standards as the financing community sought to maintain growth in mortgage debt in the face of rapidly rising house prices, while both prospective homeowners and investors/speculators eagerly participated in the process. But the environment has changed dramatically, and we're now dealing with deteriorating mortgage credit quality and a snapback in lending standards—developments that pose new risks to our projected housing market recovery.

ROOTS OF THE PROBLEM Various “affordability” mortgage products were developed and marketed during the boom. These included nontraditional mortgage loan structures, such as deeply discounted interest-only adjustable-rate loans and payment-option ARMs that permit buildup of loan principal (negative amortization). Other risky features often were layered on top of such loans, including piggyback second mortgages and underwriting procedures that required little or no documentation of the income or assets of borrowers.

THE SNAPBACK The prospects for home price appreciation have weakened dramatically and the investment community has been learning about the real risks of mortgage securities issued against pools of various affordability products. Indeed, the subprime mortgage market is in disarray, the financial rating agencies are in the game, and regulators of depository institutions have moved against the nontraditional ARM structures as well as subprime ARMs that promise to generate serious payment shock. Freddie Mac also has spoken out on the latter topic.

The snapback of mortgage lending standards gained momentum early this year in the subprime component of the market, and the shift toward firmer standards inevitably has percolated up into the Alt-A segment of the market where credit scores are somewhat higher but where little or no documentation of borrower income and assets has been required. The quantitatively dominant prime mortgage market has been affected primarily by pressures on lenders from federal and state regulators to underwrite interest-only and payment-option ARMs at their fully indexed and fully amortizing interest rates.

LIKELY CONSEQUENCES As long as the overall economy continues to perform reasonably well and interest rates remain close to current levels, further deterioration of house values will be limited and credit quality problems will be contained. Furthermore, the wide dispersion of mortgage credit risk will keep this problem from generating financial market crises in either national or international markets—contrary to well-publicized contentions by some pundits.

The real issues for the housing market are twofold: first, the number of mortgage foreclosures that will put homes back onto the markets, adding to the already heavy inventory overhang; second, the number of prospective home buyers that will be filtered out of the market by stricter lending standards in subprime, Alt-A, and prime components of the mortgage market.

History provides only limited guidance in these areas. The NAHB's current forecast assumes that the foreclosure/inventory issue will not turn out to be a major weight on the market and that the firmer lending standards will not put a heavy hit on home sales over the balance of the year. We're still projecting modest upswings in home sales and housing starts from recent lows, although breaking developments on the mortgage front obviously could pose additional downside risk. Stay tuned!