Weakening credit quality may spur long-range housing correction.

While home finance is "still very sound," the housing market is due for a major correction over the next several years as credit quality will begin to degrade in 2006--touching lower-income households and the subprime market first, concluded an expert at the National Association of Home Builders'

Mounting challenges include elevated energy costs, rising interest rates, weakening household demographics, increasing inventories of for-sale homes and a stock market poised to take back some of the money currently invested in real estate, said NAHB speaker Scott Anderson, senior economist for Wells Fargo & Co., New York.

"It's going to take a lot of [home]-price declines to eat into that credit quality," said Anderson. "This will develop over a multiyear period. 2006 is a transitional year, Act I of a five-act play."

Mark Zandi, chief economist of Moody's Economy.com, West Chester, Pennsylvania, agreed, noting that mortgage credit quality is still good, but will continue to weaken.

The most significant threat to the housing market, Zandi said, is that weakening mortgage credit quality will trigger a financial market event, resulting in a more serious decline in housing economic activity.

"Any fundamental rise in interest rates will bite hard," said Zandi. "The rise will lock out two key groups that are important to local and regional markets--first-time homebuyers and investors."

Meanwhile, look for a housing market correction rather than a crash, thanks to a sturdy job market, well-capitalized intermediaries and only modest overbuilding as home builders "have done a pretty good job of matching supply and demand," said Zandi.

Zandi forecast national home sales would fall 25 percent from peak-to-trough, as prices stall through 2007, while new construction will decline 15 percent. Furthermore, expect house prices to decline as much as 10 percent peak-to-trough in the Northeast and Mid-Atlantic regions, as well as in Florida, California, parts of Arizona and Las Vegas, said Zandi.

In the shorter term, expect mortgage interest rates to rise slowly through the end of 2006 while remaining below historical norms, according to Frank Nothaft, chief economist for Freddie Mac.

"Housing is the most interest-rate-sensitive industry in the country," he said. "Mortgage market interest rates, home prices and family incomes are the three ingredients that families think about when deciding to buy a home."

Nothaft said he did not foresee a national home-price decline, and noted that among families with prime mortgages, some 87 percent of the loans are fixed-rate, so they are insulated from further rate hikes.