For months, the steady drip of news about troubles in the subprime mortgage market looked no worse than one would expect: merely a comeuppance for lenders, borrowers and investors who should have known that high-interest loans to people with poor credit were risky.

During the same period, many economists started breathing again after concluding that the superheated home market of recent years had not become the bursting bubble many had feared. While home prices are leveling off, there has been no deep, widespread decline.

But now some experts wonder whether those sighs of relief came too soon, especially in light of the troubles recently experienced by one of the largest subprime players, HSBC Holdings. Some suggest that the growing number of borrower defaults in the "aggressive lending" market, which includes various types of risky mortgages besides subprime loans, could shock the broader housing market and economy after all. Many subprime borrowers are paying 10% to 12%, compared to 6% to 8% on standard, or "prime," loans, and delinquencies are rising.

"There’s no doubt that we have already lost about 1 percentage point of [economic] growth due to the pullback in the housing market," says Wharton real estate professor Susan M. Wachter. A retrenchment after years of soaring home prices fueled by easy money has caused many economists to trim this year’s growth forecasts from 4% to 3%, she adds.

And it could get worse, she warns. If interest rates rise, growing numbers of homeowners could fall behind on aggressive floating-rate loans they took out in recent years, forcing their homes onto the market. The glut would depress prices of homes bought with ordinary "prime" loans as well. With home values flat or falling, owners would no longer be able to use refinancing to convert equity into cash, trimming consumer spending. The current slump in home building and sales would persist. "We could potentially have a housing-led recession," Wachter says. If this does occur, it could begin in the second half of 2007 or sometime in 2008, if interest rates rise.

Others think the U.S. economy could well dodge this bullet. "I’m sort of an optimistic pessimist," says Jack M. Guttentag, emeritus finance professor at Wharton. He expects home prices to fluctuate aimlessly for two to three years without a major decline. But the future is uncertain, he adds, because many of the newer, risky loans have track records only through the recent period of rising home prices. "Rising home prices are an offset to all kinds of trouble," he notes. "They tend to reduce defaults and foreclosures that otherwise would occur, because people who get into trouble find that the best thing they can do is sell their house and walk away with some equity."

Incomplete Risk Data

In a mid-February report titled, "Will the Subprime Meltdown Trigger a Credit Crunch?" Morgan Stanley analyst Richard Berner concludes it will not, describing a credit crunch as a condition in which "lenders deny even creditworthy borrowers access to borrowing." Many firms specializing in subprime loans — offered to borrowers with credit scores below 620 — will go under, he says, but prime lenders’ balance sheets are strong and he expects them to continue making loans and keeping the economy healthy. (Credit scores range from 300 to 850, with scores above 700 generally considered good and those below 600 counted as very high risk.)

While there is debate over how matters will unfold, there is little doubt that changes in mortgage lending have created risks that cannot be gauged precisely. Wachter notes that the heavy use of aggressive loans is so new that data on which lenders and investors base their risk models is incomplete. "There is the potential for model error. The models are untested in a down market."

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