IT'S NOW PERFECTLY CLEAR THAT THE UNSUSTAINABLE booms in single-family and condo markets during the 2004–2005 period were fueled by major deterioration of mortgage lending standards, and we now know that those standards continued to weaken in 2006 even as home sales and house price appreciation were faltering.

The mortgage lending pendulum began to swing back early this year as credit quality problems became starkly evident, particularly in the subprime sector, and we're now in the midst of a major mortgage credit storm that has already laid a recession-sized hit on the housing markets and promises to weigh heavily on the markets for some time.

Policy makers recently recognized the seriousness of the situation and started crafting partial solutions, although these efforts focus primarily on homeowners now bearing the burden of earlier lending excesses rather than on the functioning of mortgage markets going forward. In any case, there's no easy or quick fix for the current turmoil in mortgage credit markets, and builders must focus immediately on the most promising sources of credit for prospective home buyers.

NEW RULES Builders should realize, first of all, that the dangerous risk-layering practices that proliferated during the boom are all but gone. Prospective buyers/borrowers now must be able to verify their income and debt positions, and piggyback seconds can no longer be used indiscriminately to eliminate the need for real down payments.

Also note that the so-called “affordability” products in the adjustable-rate mortgage market(deeply discounted interest-only and payment-option ARMs) have virtually disappeared as regulators have clamped down on lax underwriting practices and the investment community has recoiled. These loans now must be underwritten at their fully indexed interest rates and fully amortizing monthly payments that have gutted their attractiveness to borrowers.

WHERE TO GO? With respect to fixed-rate, first-mortgage financing (FRMs), builders should look first to loans that are insured or guaranteed by the federal government (i.e., FHA or VA loans). These programs fell out of favor when the nonprime markets (subprime and alt-A) were growing rapidly, but both now are regaining ground and legislative policy enhancements to the FHAprogram may not be far down the line. Not only are FHA and VA loans federally backed, but they normally are packaged up and sold as Ginnie Mae–guaranteed securities—a gilt-edged package that even the most risk-wary investor should be willing to buy at essentially the same yield relationships (to Treasurys) that prevailed before the meltdown of the nonprime markets.

FHA/VA/Ginnie Mae loans are subject to size limits, of course, but the loan-purchase programs of Fannie Mae and Freddie Mac provide solid support to the fixed-rate prime conventional mortgage market up to the “conforming” loan-size limit (currently $417,000). These government-sponsored enterprises (GSEs) do not enjoy full-faith-and-credit federal backing of their debt or mortgage-backed securities issues, but the global financing community still views their securities as having attractive “agency” status. Yield spreads for prime mortgages eligible for sale to the GSEs recently have widened out to some degree (relative to comparable-maturity Treasurys), but there's no credit-availability or “liquidity” issue in the GSE space.

The most recent casualty in the global stampede to credit quality has been the prime “jumbo” mortgage market—loans to creditworthy buyers that are above the $417,000 conforming loan limit. The securities market for jumbo loans actually shutdown in August for both ARM and FRM financing, a casualty of the global confusion over the quality of any mortgage product not backed by the federal government. This liquidity issue eased off to some degree by September as some large portfolio lenders announced that they still were in the market, although yield requirements on prime jumbo loans have increased substantially. That situation is likely to prevail for some time.