March 14 (Bloomberg) -- For a brief moment at the start of the new year, data showing gains in new home sales and declining inventories of unsold properties were starting to beef up the credibility of those taking a bullish stance on housing.

Bleak data released in February on everything from loan applications to housing starts to the subprime mortgage plunge made that moment especially brief. The main subject in dispute is whether the subprime woes are an isolated problem or one that might have a larger impact on the economy.

Those who fall into the subprime isolationist camp argue that when you consider the size of the subprime adjustable-rate mortgage market, even a significant amount of distress just doesn't add up to a macroeconomic event.

Federal Reserve Governor Susan Bies argues that subprime ARMs make up only 7 percent to 8 percent of the $10 trillion dollar mortgage market. Doug Duncan, chief economist of the Mortgage Bankers Association, says that only 6 percent of homeowners hold subprime ARMs. By their logic, even if we saw a 20 percent default rate among subprime ARM holders -- a rate twice as high as the foreclosure peak after the 2001 recession - -that is still just over 1 percent of the full national mortgage market.

While these statistics somewhat undercount the subprime market (add in subprime fixed-rate loans and they make up closer to 13 percent of the market) the main flaw with the subprime isolationists' case is the narrowness of their inquiry. The issue isn't whether the subprime market is big enough to put a dent in an otherwise healthy housing market. The right question is in the context of a still shaky housing market, and whether subprime defaults might delay a housing recovery or presage a bigger shock due to relaxed lending standards in 2005 and 2006.

Signs of Weakness

This year started with evidence of significant excess in the supply of homes for sale, which could portend declines for home prices, mortgage-equity extraction and residential investment. Not only do the 4.1 million housing units for sale represent almost seven months of supply, but housing completions are still near their historic highs and will only add to the backlog.

Another sign of weakness can be seen in the homeowner vacancy rate -- the percent of non-rental housing units that are empty and for sale. In the fourth quarter of 2006 the rate rose to 2.7 percent -- a record. The 0.7 percent increase in the homeowner vacancy rate over the last 12 months is twice as large as the next biggest annual increase seen at any time in the last 50 years, according to Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. It is against this backdrop that one must evaluate the impact of a projected fall in subprime mortgage originations from $600 billion in 2006 to $400 billion in 2007.

More Fallout

Yet the largest concern with subprime loans may be the possibility that they are part of the broader fallout from the recent explosion of risky mortgages.

Subprime loans, which constituted 20 percent of all mortgage originations since 2005, come on top of a surge of risky ARMs to credit-worthy borrowers in recent years. Because many of these ARMs included features such as teaser rates for two years, no money down, alternative documentation methods, and interest-only options (to defer repayment of principal), they bear the potential of future payment shocks.

In a speech last May, Fed Chairman Ben Bernanke said that 30 percent to 40 percent of all mortgage originations in 2005 fell in this ``nontraditional'' category. Considering these figures, the subprime story starts to look like a chapter in a book about how lenders relaxed standards across the board in 2005 and 2006, in order to keep up fevered origination volume even as home prices and interest rates rose.

Shaky Loans

As reported in the Wall Street Journal last spring, Credit Suisse Group found that prime ARMs originated in 2005 were three times as likely to be delinquent after one year compared with similar loans made in 2003 or 2004. And the National Association of Realtors has said that an amazing 40 percent of first-time homebuyers in 2005 and 2006 put no money down on their homes!

The reality of risk far beyond subprime mortgages raises critical questions.

How many of the $1.5 trillion ARMS that could reset in 2007 will result in payment shock? How much should we worry that such payment shocks come at a time when we have high debt levels and negative private saving rates not seen since the 1930s? How many foreclosures due to exotic loans, combined with those in the subprime market, does it take to lead to tightening credit? And how much worse is the answer to each of these questions if the labor market weakens, and more families face the triple punch of lower home values, higher mortgage payments and shakier paychecks?

I am not suggesting that the answer to these questions is doom and gloom. But I don't think you get an enlightened view of the risks in housing by focusing only on the size of the subprime ARM market.

(Gene Sperling, author of ``The Pro-Growth Progressive,'' is a Bloomberg News columnist. He served as President Bill Clinton's top economic adviser, and he is a senior fellow at the Center for American Progress. The opinions expressed are his own.)

To contact the writer of this column: Gene Sperling in Washington at gsperling@cfr.org.

Last Updated: March 14, 2007 00:03 EDT