Much has been made about how housing undergirds the economy over the past decade, and rightly so. Housing has been the money engine fueling the greater economy by providing both the source and object of consumer spending. So it is with considerable trepidation that the state of housing and mortgage lending comes into sharper focus. Massive numbers of jobs, gobs of spending dollars, and the basis of enormous wealth are at risk.

Any subject can seem a bit ho hum when it suffers from overexposure in the media, such as the subprime mortgage saturation in recent weeks. In the case of subprime mortgages, the recent coverage is definitely deserving of our attention.

High interest rates have historically been the chief nemesis of the housing industry. Interest rate cycles have taken enormous bites out of property values and real estate activity in previously years.  Rising rates left large inventories of both existing and new homes. When mortgage rates fell potential homeowners waiting in the wings stepped forward to income qualify for and purchase homes and the housing market subsequently returned to healthy activity and growth.

However, today’s housing situation gives cause for real concern.

First, interest rates continue to hover at historically low levels. Rates are not placing qualified buyers on hold nor have rates driven them away.

Second, when buyers became scarce rather than allowing the housing market cool off naturally lenders tweaked with income, credit and debt-to-income and loan-to-value ratios and created a firestorm of at best marginally qualified buyers, accelerating housing prices to unsustainable heights.

Now that the smoke is clearing, no one likes the landscape; not real estate brokers and agents, not mortgage lenders and brokers, not builders or the trades and supporting industries and certainly not Washington.

It is imperative that we identify the root cause of today’s housing market retreat and address those problems. Let’s not cast too broad a blame to further harm the industry or jeopardize its healthy recovery by destroying a key solution - subprime mortgages.

Data from the Mortgage Bankers Association (MBA) shows that delinquency rates are steadily climbing on more than 40 million first mortgages.

Data from the MBA and LoanPerformance show that delinquency rates on subprime first liens are much higher than on subprime second liens. It is estimated that the largest portion of subprime second liens consists of borrowers whose first mortgages are classified as prime. According to Moody’s Economy.com, “This suggests very lax underwriting standards on subprime first mortgages, and perhaps even some predatory lending.”

Given the climate within the housing industry and in Washington, considerable energy is being devoted to identify what is at the core of the housing implosion, what measures can be taken to ease the negative economic impact and what additional measures are needed to better assure a non-repeat. We can only hope that prescription doesn’t exacerbate the conditions.

Last week Mark Zandi, chief economist for Economy.com, outlined an enlightened approach to ease the foreclosure tsunami about to sweep the housing industry.

Mortgage foreclosures are surging and the political heat is on. There are calls for something to be done given the financial pain lower-income and minority households, and the communities in which they live, will soon face. He points out, “The odds are high that policymakers will overstep and ultimately harm the very households they hope to help. They also risk undermining the fragile housing market, and by extension, economic expansion.”

Improve the information base. The lending industry does not keep accurate totals of homes in foreclosure. This information is readily available on the annual (anti discrimination) filings reported by lenders for years. Accurate information on who is losing their homes will help policymakers determine what lending practices are behind the escalating foreclosures.

State foreclosure laws need greater uniformity. Everyone would benefit with standardized and transparent laws. Recent national bankruptcy reform laws are a great example to follow.

Lenders and borrowers should have to prove that they understand the loans they are originating and taking on, respectively. Regulators should aggressively enforce tougher licensing standards for lenders, and require borrowers to attend a class, paid for by the lender, that walks them through the scenarios they face when taking on a complicated mortgage.

The FHA and VA should receive temporary authority to expand lending activities to fill the void left by exiting lenders.

The regulatory bodies that oversee mortgage lending should be consolidated and streamlined to simplify and economize compliance requirements. A single regulatory body with the responsibility and clear authority to oversee the industry could reduce oversight cost and offer a quicker response to problems. This body should reside in the Federal Reserve or similar non-political institution.

Congress should not impose an explicit definition of a “suitable borrower,” which can change over time and economic conditions.

Regulators should not adopt their proposed guidance for subprime lending as currently written. These and existing guidelines require that a buyer be qualified based on the loan’s fully indexed rate. A loan payment fully adjusted from the teaser rate at the same time lenders are raising their lending standards could send the mortgage and housing industries into a tailspin. “It is important not to cut off the credit so critical to a well-functioning economy, and that at the end of the day has made many Americans homeowners.”

To Washington, subprime lending was good as long as it propped up the economy and stimulated consumer spending. While it sustained the real estate industry and supplied substantial fuel to recent economic growth, it was hands off.

That was then and this is now. The excesses of subprime lending have set up the real estate industry and possibly the greater economy for a very rough road. You cannot expect to radically relax credit standards, liberalize equity and down payment standards and throw billions at the market and not expect there to be a day of reckoning.

The Setup
Aggressive underwriting and lending has effectually “borrowed” tomorrow’s traditionally qualified homebuyers, leaving the housing market in search of new markets.

The insatiable appetite of the industry and public led to the creation of a new market of homebuyers that were not traditionally qualified.

The Fall
 We are just now beginning to see the impact of all of this:

Overwhelming financial pressure on marginal income families who can’t support the rising payments on their ARM mortgages;

Investors in these mortgage-backed securities now face considerable risks and have pulling away from these products;

In some markets this activity pushed home prices higher; some say “artificially.” If so, look for market corrections until supply and financing balance with more traditionally qualified buyers.

Proceed With Caution
Subprime lending has and continues to play a valuable role in real estate. The majority of subprime borrowers are meeting their financial obligations and subprime lending has opened  the door to thousands of responsible buyers who would otherwise not enjoy homeownership.

Don’t Kill The Goose
Last week economy.com joined the subprime discussions. Economist Augustine Faucher authored a report titled “Don’t Kill Subprime Lending” in which he eloquently highlighted the current debate.

“With the recent fallout in subprime lending, policymakers are looking at greater regulation of the industry.”

“Subprime lending has played an important role in democratizing credit and has led to gains in the homeownership rate.”

“Market forces are discouraging some of the excesses in subprime lending. Greater regulation of the industry could make it more difficult for low-income households to borrow and purchase a home and could weigh on consumption [consumer spending].”

Mr. Faucher cautions us not to confuse subprime with exploitation or “predatory” lending.