One of the reasons for lending to subprime borrowers is that, besides their profit potential, banks are obligated by law to offer lending services to clients of all income and credit levels. "The social and political forces at work suggest that credit availability is a good thing," says Tom Vartanian, a Washington, D.C. partner at law firm Fried, Frank and former general counsel of the Federal Home Loan Bank Board and the Federal Savings & Loan Insurance Corp. Vartanian points to the Community Reinvestment Act, passed by Congress in 1977. The Act requires that insured financial institutions such as commercial banks offer equal access to lending to all those in an institution's geographic assessment area. Before the CRA, many bankers excluded low-income neighborhoods from their lending products.

Even if banks have to adhere to stricter lending standards, it's likely that they would have implemented them anyway since they don't want to lose any more money. "They do such a good job of managing risk in other businesses I would assume their standards are tighter [than those of other lenders]," says Albrecht.

Nonbank mortgage lenders have also been tightening their standards. The trend picked up after government-sponsored mortgage financier Freddie Mac said on Feb. 27 that it will no longer buy high-risk mortgages. Federal Reserve chief Ben Bernanke has also urged Congress to boost regulation of Freddie Mac and its government-sponsored-enterprise sister, Fannie Mae.

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The government can't regulate independent lenders, but lenders will continue to tighten standards anyway over the next year to cauterize their losses, Plesser says. "In general lenders are being much more careful."

Unmanageable interest rates
Tighter standards are locking a large part of the American population out of home buying, especially first-time home buyers: "The same person who went for this loan three months ago wouldn't be able to qualify now," Plesser says.

Many others are being forced into foreclosure because their credit is no longer good enough to refinance, like Trisca Jackson of Lithonia, Ga., an Atlanta suburb. Jackson, an employee at a wireless communications company, bought a house for $129,900 in 2002 with zero down by using two loans. She covered 80% of the purchase price with a 3/27 adjustable rate mortgage starting at 8.25% and the remaining 20% with a 30-year fixed-rate loan at a rate of 12.25%.

At the end of the three-year "teaser period" Jackson could not qualify for a better loan, and her payment rose to $1,500 a month from the original $946. She tried unsuccessfully to sell the house (two potential buyers' financing fell through) and eventually had to foreclose.

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BusinessWeek: Making sense of the mess
Blacks suffer most in U.S. foreclosure surge
Q&A: Will woes ripple through economy?

Rising values could offset defaults
As credit becomes tighter, it's going to be harder for homeowners like Jackson to make payments, adding insult to the injury of stagnant home prices and slipping sales. But a market of escalating home values will prove favorable to subprime lenders, who lend based more on a home's value than on an individual's credit score. According to the National Association of Realtors, the national median home price will rise 3.4% in 2008 after growing just 1.9% in 2007 and 1.1% in 2006.

"Subprime lending won't go away," says Vartanian. "There will always be upturns and downturns and overreactions to downturns—my concern is that overreaction doesn't gobble up the good [aspects of subprime lending] with the bad."

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