The sometimes questionable underwriting practices of subprime lenders such as Freemont General (NYSE: FMT), New Century Bancorp (Nasdaq: NCBC) and Accredited Home Lenders (Nasdaq: LEND) have been well documented in the media of late.

Lower interest rates are a tease for hawkers of variable or adjustable rate mortgages (ARMs) who lure unsuspecting aspiring homeowners with dodgy credit to what often end up being usurious and consequently unsustainable arrangements for the mortgagors, resulting in the scourge of a lost home, even poorer credit or, worse, personal bankruptcy.

Falling home prices exacerbate this maelstrom. Loss mitigation efforts of the lender, whereby struggling borrowers are given reworked terms to forestall the inevitable, often are for naught.

The situation is analogous to a company's earnings quality. Workout terms are at times quite unconventional. Finance companies are feeling this and the public is not privy to the extent of the rot due to the lack of transparency in the process. What is difficult to know is whether or not the practice is predatory.

How The Seeds Are Sown
Subprime mortgages make up a small portion of the overall home finance market, but their growth in the past few years has been quite strong. Additionally, their role as a key ingredient in securitization is big business for Wall Street firms such as Lehman Brothers (NYSE: LEH) and Bear Stearns (NYSE: BSC).

Couple this with the difficulties in valuing mortgage backed securities that hold these mortgages, the run-up in premium rates on credit derivatives that investment banks buy to lay off the risk of their fixed income holdings-almost one half is in mortgage backed securities -- and the pullback in residential mortgage-backed securities (RMBS) issuance and it is plan to see that investors' concerns are not misplaced.

Finally, investment banks such as Morgan Stanley (NYSE: MS), Bank of America (NYSE: BAC) and Deutsche Bank (NYSE: DB) that provide credit facilities for the mortgage lenders whose mortgage backed securities get repackaged are on the hook themselves. As well, certain fixed income mutual funds such as Regions Morgan Keegan Select High Income Fund and Legg Mason Partners Capital and Income Fund in some measure hold mortgage-related debt of these subprime lenders.

For now, it is difficult to gauge to what extent any contagion will be felt in the mortgage market as credit risk tends to play out more slowly over time. Were investors who had no idea that they might own such debt in their portfolios, such as pension funds holding complex derivatives such as collateralized debt obligations (CDOs), to discover to their chagrin that they did and were they to exit illiquid portfolios en masse, then capital markets could receive a nasty shock.

Possibly the only beneficiaries from recent events are hedge funds on the right side of trade (e.g. shorted subprime) and distressed debt buyers, and recent events such as these serve as an important reminder of times past.

Spare a Thought for 1989
What appears to be less well-documented in all of this is the cyclicality of financial progress, and one need only go back to the mid to late 1980s for perspective.

Fueled by a failure of public policy that resulted in deregulation, banks assumed greater investment risk, lending long and borrowing short, an asset-liability mismatch that resulted in a number of high profile failures of numerous savings and loan institutions. The rollover of nonperforming loans on the books of those thrifts magnified the crisis and the Resolution Trust Corp was established to sort out the mess.

Present day loss mitigation would seem to auger a similar outcome. Additionally, the markets practiced their own form of high risk underwriting in the form of high yield (junk bond) issuance as championed by the likes of firms such as Drexel Burnham Lambert. Private equity firms (buyout firms as they were formerly known) would arrange the purchase of publicly traded firms putting up only a small portion of the purchase price and employing leverage to finance the remainder.

The newly private companies, much as the present day encumbered homeowners, would struggle to operate under the weight of an indebtedness for which they proved to be no match. The architects of these arrangements, meanwhile, often made out rather well as the strictures of debt financing led them to invoke often extreme cost cutting measures to boost returns.

Examples of companies once caught up in the snare include grocer Safeway (NYSE: SWY) and the holding company of Canadian financier Robert Campeau who employed leverage in the acquisition of Allied Department Stores and Bloomingdale's.

It Can Happen To You
Excess is brought about by a catalyst. In the late 1980s, it was both financial deregulation and the perceived failure of the public markets to deliver value to many companies that led corporate managements to seek greater value and employment security away from such markets. It ended up often enough being a ruse.

Of late, eager home buyers, low interest rates and investors' inexorable appetite for yield have all figured prominently.

Caveat Emptor
It's a hackneyed phrase, yet one to which many homebuyers, prospective or otherwise, seem to have paid too little attention.

The desire of home ownership and a low interest rate environment fueled the ambitions of lenders to create products that would make the barely affordable or unaffordable, well, affordable...or not, as has frequently been the case.

Tulip mania, the South Sea bubble, speculation in the unfettered markets of the 1920s...the lessons seem to repeat themselves often enough, yet enough people fail to learn from them. Progress is as progress does and while it may be cyclical, it is progress nonetheless.

From the early corporate wreckage, high yield finance has evolved into a mainstream subset of fixed income. A desirable result of the current debacle would be greater and clearer disclosure to prospective customers and more prudent underwriting by the financial institutions.

As we await the outcome, we would do well to ponder where the fault line rests for the next market tumult and whether policy makers and investors will have enough foresight to see it off before it is too late. The answer is predictable enough.

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!