(This is Part 3 of a five-part series. See Part 1, Part 2, Part 4 and Part 5.)

In the first two articles in this series, I explained the immediate cause of turmoil in the subprime market as the ending of house-price appreciation, and the underlying cause as a myopic tendency for lenders to make loans that worked only if house prices continually rose. This article focuses on the current state of the market.

The Current Pain: The 32-odd subprime lenders who failed have garnered the least sympathy. Put simply, they gambled and lost. But some borrowers fall in that category as well because they were looking to profit from house-price appreciation. Instead, they are facing foreclosure.

Investors in securities issued against pools of subprime mortgages have also felt pain, as the market value of these securities has declined. Lehman Brothers estimates the decline at $19 billion. Most of it is concentrated among the riskiest of the securities, which promised the highest yields. (No collection plates are being passed for them, either.) Securities rated AAA, which are first in line to be repaid and last in line to take losses, have been impacted very little.

Mortgage brokers have not been significantly affected. A few have lost access to subprime lenders, but most of them have been able to replace defunct lenders with other lenders.

The big losers are those borrowers who, as unwitting victims of hype and deception, took out mortgages that were unworkable if house prices stopped rising. Now that prices have stopped rising, many of these borrowers are waiting for the next shoe to drop. They have adjustable-rate mortgages (ARMs) on which the rate will reset to a much higher level within future months.

The Subprime Market Remains Open: This is the good news, and it should not be taken for granted. When the international banking crisis erupted in the early 1980s, the market adjustment stretched over a decade during which there was virtually no new lending.

The subprime lenders who remain are the more cautious ones. They are also more likely to be affiliated with other firms with deep pockets, which will help them ride out any future market disturbances.

Of course, the profit potential in subprime lending is not what it was. Investors require a higher yield than before, especially on the riskiest securities. This has caused a tightening of underwriting requirements that has effectively lopped off the riskiest segment of the market.

Underwriting Requirements Are More Restrictive: Underwriting requirements are the conditions that borrowers must meet to be eligible for a loan. They are significantly more restrictive now than they were a year ago. One of the most important shifts is the virtual disappearance of the 100 percent (no-down-payment) loan.

Periodically I receive an advertisement from a subprime wholesale lender rep advertising what is available from his firm. (He thinks I am a mortgage broker.) One came to me on April 19, 2007, showing that a borrower with a credit score of 620 (which is low) could qualify for a loan of $650,000 with a down payment of 10 percent. Checking back in my “Deleted Items” archive, I found a message from the same rep dated June 20, 2006. At that time, he was offering the borrower with a 620 score a loan of $1 million with nothing down.

The 2006 offer was insane, a product of the euphoria created by steadily rising real estate prices. The current rules are no longer based on the inevitability of rising prices.

Prospects: If house prices begin to rise again this year, the problems of the subprime market will go away. In 1998-99, we had a similar episode in which as many as 20 subprime lenders failed. But in 2000, house prices took off, the problems disappeared, and few people today even remember the episode.

This time, however, the prospects for a quick revival of house-price appreciation are very poor; a further weakening is much more likely. Under these conditions, there is an ominous cloud on the horizon: subprime borrowers who took 2/28 ARMs in 2005 and 2006 will have their interest rates and payments reset to much higher levels during the remainder of this year and next. A significant number will not be able to make the new payments, and won’t be able to refinance because the equity in their houses is not sufficient to meet the new underwriting requirements. They face foreclosure.

What if anything should be done about that is discussed next week.

The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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