Housing market enters season of reckoning

The somber outlook marks a dramatic shift from the euphoria that prevailed in 2005. Years of steadily rising home prices had spawned a giddy, greed-driven atmosphere that seemed to make people forget about a basic law of economic gravity: what goes up eventually comes down.

As housing prices soared, lenders entrusted more money to borrowers who probably would have been turned away under more normal market conditions.

The risky behavior propelled the rapid growth of subprime mortgages — home loans designed for borrowers with blemished credit histories. By some estimates, about $1.3 trillion has been lent to subprime borrowers across the country. That’s nearly as large as California’s economy.

Subprime mortgages invariably carry higher interest rates, but lenders lessened the burden by charging extremely low introductory rates or initially waiving all interest payments. Some borrowers weren’t even required to provide proof of their incomes to qualify for the most exotic mortgages.

Lenders made these loans largely because they felt protected by rising home prices: As long as property values were climbing, subprime borrowers would be able to refinance into another affordable mortgage once the payments on their earlier loans increased. If that didn’t work, subprime borrowers would be able to bail out by selling their homes at a tidy profit.

But weakening home prices have exposed the folly of that premise. With borrowers defaulting on their mortgages, more than two dozen subprime lenders have closed or filed for bankruptcy.

“Giving mortgages to people who couldn’t afford them was the biggest error of recent years,” Shiller said.

Pressured by federal regulators, subprime lenders have turned off their spigots.

The tougher lending standards are expected to remove 100,000 to 250,000 potential buyers from the housing market during the next two years, estimated David Lereah, chief economist for the National Association of Realtors. That by itself could decrease home sales by up to 3 percent.

“It’s problematic, but not catastrophic,” said Lereah, who is counting on still-low mortgage rates and a strong labor market to help soften the subprime blow.

If the Federal Reserve Bank cuts interest rates later this year, it could help reduce the foreclosure rate by lowering the monthly payments of troubled borrowers with adjustable rate mortgages.

It probably will take months to get a handle on the damage caused by the subprime mortgage spree. The severity will largely depend on how many delinquent borrowers lose their homes to lenders in foreclosures. Mass foreclosures could create a glut of homes on the market, squashing property values even more.

Homebuilders have been hard hit. In addition to Lennar, KB Home, Hovanian Enterprises Inc. and Toll Brothers Inc., also have reported disappointing earnings.

D.R. Horton Inc.’s chief executive, Donald Tomnitz, probably summed it up best in early March when he publicly declared the housing business will “suck” the entire year.

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