The free-wheeling, frenzied-borrowing casual lending practices in play over the last few years have generated warnings from all quarters of the financial sector about the danger of overextended consumers and irresponsibly designed loans. The first signs of these warnings becoming reality became apparent this week as the Mortgage Bankers Association issued their quarterly report on homes in foreclosure. MBA said Wednesday that loans entering foreclosure during the second quarter rose 29 percent from the first quarter.

One Merrill Lynch analyst wrote “This is the first sign of meaningful weakening in the prime mortgage space…A downturn in credit may be just around the corner.”

The meaning for mortgage lenders is this: if consumers start defaulting on mortgages, investors who buy mortgages in the secondary market through loan-backed bonds will lose their appetite for risky loans. Mortgage lenders will then either make less profit when they sell their loans through securitizations or be stuck with portfolios of undesirable loans, leading to bank owned foreclosures. Government insured loans that go into foreclosure don’t impact the banking industry, but homes in foreclosure on bank owned mortgages cost the lending institution an average of ,000 to close out.

What it will mean to consumers is that credit terms will tighten and maybe – just maybe – banks will reconsider handing out option ARMs and interest only loans to anyone who walks in the door. Some analysts think easy credit conditions and a housing boom may have led lower-income consumers to bite off more than they can chew; thus the sudden jump of homes in foreclosure.

During the housing boom many home buyers with weak credit took out exotic mortgages such as adjustable-rate loans, which have payments that reset when interest rates rise. Now that interest rates have risen substantially and the rates are resetting, analysts fear a continued rise of homes in foreclosure. Other analysts believe that the defaults won’t continue on a steep upward curve unless unemployment rises. However the abrupt downturn in new housing starts that has already occurred may well launch a softening employment market.

What does this mean for those of us who want to buy a house in this market that is finally cooling? It means that bank owned foreclosures are going to force financial institutions to tighten their credit requirements. It may mean the removal of some of the more blatant teaser-type mortgages from the market, which would be to everyone’s benefit. It’s a fair guess to say that many or the people with homes in foreclosure didn’t understand the terms of their ARM entirely.

Bank owned foreclosures as well as government-sponsored mortgage foreclosures will also lead to an increase of foreclosed properties going on the market. If you’ve seen the hundred and one get-a-house-for-nothing advertisements for guides to buying in the foreclosure market, understand that generally speaking this is not a market for amateurs. There’s more to evaluating a home in foreclosure than looking at comps in the area. Most auctions require you to plunk down a substantial sum of cash to participate; finding a bargain in the foreclosure market takes patience, research, great caution and cash reserves.

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