As more homeowners run into trouble making loan payments, it is not just borrowers and lenders who are at risk, but the US economy as well.
The danger is that banks will feel impelled to tighten credit standards too much, possibly extending beyond mortgages to other forms of consumer and business lending. This could slow both business investment and consumer spending at a time when the economy is already in a stretch of below-normal growth.
Worry about a possible "credit crunch" was one reason that stock prices took a dive Tuesday. The Dow Jones Industrial Average fell by 2 percent, to 12075.96, after the Mortgage Bankers Association reported that the percentage of loans entering foreclosure hit 0.54 percent in the final quarter of 2006, a record high and a jump from 0.46 percent three months before.
At the very least, this appears to portend more difficulty in the housing market. Banks have already been tightening standards on home loans – especially in the troubled category of subprime loans, which are aimed at the least creditworthy borrowers. Whether it prompts banks to tighten credit more broadly remains to be seen.
"If they tighten up on commercial and [business] loans, then that would really spell a problem" for the economy, says Rajeev Dhawan, director of the Economic Forecasting Center at Georgia State University in Atlanta.
"Housing activity will be weak for this year," he says, and he expects that consumer spending will also take a hit from a chill in credit.
This elevates the risk that the economy could enter a recession. But Mr. Dhawan believes the Federal Reserve will cut interest rates in late spring, particularly if Fed policymakers see signs that the economy is being squeezed by a lack of credit. That should be enough to avert a period of outright decline in economic activity.
Still, a tougher road for the economy, even with no recession, means a tougher time for consumers and for the stock market.
Real estate is the main item on most homeowner balance sheets, and the perception that home values are declining or unstable could affect the psychology of spending.
"Our biggest concern is that any tightening of lending standards in the mortgage market – even if confined to lower-quality borrowers – is going to constrain overall housing demand and make it more difficult for home sales and prices to stage a recovery," Merrill Lynch economist David Rosenberg wrote in a report Tuesday.
"The housing market has actually been in a recession for the past five quarters," he said, "and it's normal to have the credit part of the cycle react with a lag."
The mortgage market woes have been worst among lenders that specialized in the subprime market. A boom in subprime lending has had benefits, analysts say, since it has opened the door to homeownership to many who could not afford it in the past.
But more of those loans are going delinquent.
On Tuesday, the New York Stock Exchange suspended trading in shares of New Century Financial, a prominent subprime lender, and began taking steps to delist its shares from the exchange, citing the company's worsening financial prospects. The company also faces an inquiry by the US Attorney's Office for the Central District of California into possible criminal activity in its bookkeeping and other matters.
But if New Century is a high-profile disaster, the loan-delinquency problem extends broadly through the banking sector.
On Tuesday, shares of many large banks saw their share prices fall, as did insurance companies exposed to home lending.
Delinquency rates have been rising for all types of loans, not just subprime, according to an analysis written Tuesday by Jan Hatzius, an economist at Goldman Sachs in New York.
But the problems are rooted more in adjustable-rate loans, rather than fixed-rate loans.
"Fixed-rate subprime delinquencies have only risen by 39 basis points [0.39 percentage points] over the past year and are still far below the levels seen in the 2001 recession," Mr. Hatzius said. "Meanwhile, prime adjustable-rate delinquencies have soared by 85 basis points or 47% and are already comparable to the levels seen in the 2001 recession."
When banks or other lending companies issue a mortgage, their loans are then typically packaged into securities that are sold to investors. To a large extent, what banking companies are doing now is responding to new demands from investors regarding the risk of loans.
"They need to be sure that the loans ... are acceptable to the final investor," says Mike Fratantoni, a senior economist of the Mortgage Bankers Association in Washington.
This process will continue to evolve, he says, and the result is likely to be that it's harder for some borrowers to get a home loan. That's because the interest rates go higher or the borrowers may need bigger down payments.
Still, he predicts that these effects will be largely contained in the subprime sector.
Meanwhile, Congress also has its eye on lending standards.
Lawmakers are considering bills designed to crack down on predatory lending. One would require that lenders consider the ability of borrowers to pay back their loans over the entire term of the mortgage. This measure is designed to prevent lenders from issuing loans based merely on customers' ability to pay initial "teaser" interest rates.
• Material from the Associated Press was used in this report.