Can the housing “correction” get much worse? September housing starts were down by 10%. Building permits, a portent of future starts, declined by 7%. September sales of existing homes fell by 8%, to an annual rate of 5 million, the lowest since 1999, and median home prices declined by 4% from the prior year. Sales of new homes, released yesterday, rose by 5%, but were 23% lower than a year ago.

To make matters worse, on Wednesday Merrill Lynch, the biggest underwriter of securities backed by subprime loans, admitted that its third quarter losses totaled $8 billion, significantly more than the $5 billion announced 3 weeks earlier. If Merrill Lynch’s estimates are off by 60%, perhaps others are not far behind?

It remains to be seen how the steep declines in housing construction and sales from their abnormal 2005 peaks and the choking effect on lenders of subprime loans gone bad will affect the rest of the economy.

One political consequence is definite: Congress, federal regulators, think tanks, professors, and others are talking about new laws and rules to prevent a recurrence of the problem.

The negative news from Merrill Lynch came as Massachusetts Rep. Barney Frank, the Democratic chairman of the House Financial Services Committee, was holding hearings on his bill, “The Mortgage Reform and Anti-Predatory Lending Act of 2007.” At the same time, the Hudson Institute was hosting a seminar entitled “Addressing the Subprime Mortgage Crisis.”

Economists estimate that the housing situation alone will substantially reduce GDP growth, but it’s difficult to forecast the total indirect effect of credit problems on economic activity.

For now, increases in nonresidential construction employment, chiefly office buildings, are sopping up workers idled in the housing sector. Total employment, admittedly a lagging economic indicator, is still expanding, and real wages are rising at rates not seen since 1998. Consumers continue to spend, not from home equity loans, but from current income and expected pay raises.

Although the larger consequences of the subprime debacle and housing slump remain unclear, the “let’s-fix-it crowd” has marched on stage. Just as the Enron, WorldCom, and Tyco auditing problems spawned the burdensome Sarbanes-Oxley legislation, which led to some publicly-owned companies setting up shop in London, Paris, or Hong Kong, the subprime problems could lead to over-regulation.

Take Mr. Frank’s bill. Section 103 prohibits “mortgage originators from steering, counseling, or directing a consumer into any residential mortgage loan that is not in the consumer’s interest.” And Section 104 requires originators “to act solely in the best interest of the consumer, including finding the residential mortgage loan that best meets the needs of the borrower…”

This is surprisingly vague language to come from an experienced legislator like Mr. Frank.

It’s difficult for consumers to work out what kind of loan is in their “best interest,” even when lenders proffer all the facts. Calculations of fixed or adjustable interest rates depend on estimates of future income and guesses about future interest rates and inflation. Even mortgage originators with financial expertise can be wrong about the future. Make lenders liable for wrong guesses and some will drop out of the lending business, shrinking consumers’ borrowing opportunities.

Moreover, there is something philosophically amiss with a law that declares that lenders must calculate what is in borrowers’ best interests. This is akin to making auto dealers determine what car shoppers should buy. Full disclosure is essential, but consumers ultimately must choose desired levels of risk and take responsibility. In the end, government cannot — and should not try to — protect us from all consequences of our choices.

Governor Randall Kroszner, a member of the Federal Reserve Board, put it this way in testimony before Mr. Frank: “The Mortgage Reform and Anti-Predatory Lending Act of 2007 would require originators to present borrowers with loans that are appropriate to the borrower’s circumstances.… However, it is critical to carefully craft such laws or rules to ensure that they do not inappropriately reduce credit availability in the mortgage market, to the detriment of consumers.”

Despite the risk of over-doing it and of enacting another Sarbanes-Oxley, more regulation may be needed. The recent swings in the financial industry are not good for borrowers, lenders, or the economy, and credit markets are stalled due to pricing difficulties. Many loans were originated, packaged, and securitized without the originators having any financial liability at all. It’s practically impossible for purchasers of bundles of mortgage-backed securities to inspect the soundness of every mortgage they buy.

Desmond Lachman, resident fellow at the American Enterprise Institute and a former strategist at Salomon Smith Barney, argues that what is needed is a framework that harnesses markets. He proposes requiring originators to be capitalized and to hold a percentage of the mortgages that they originate. This would induce them to exercise greater due diligence in originating loans since they would now have a direct stake in those loans’ long-run performance. This elegant proposal, by aligning the interests of the different players, succeeds in minimizing invasive regulation while protecting consumers and investors.

John Weicher, Hudson Institute senior fellow, notes that most legislative proposals say nothing about giving potential homebuyers better information about the mortgage. The disclosure forms are complicated and confusing, and need not be specific until the actual closing, when borrowers have almost no choice but to sign whatever is put in front of them. Simple and clear disclosures, binding on lenders once borrowers accepts them, will go a long way toward preventing abuses, he believes.

Mr. Kroszner testified that by the end of this year the Federal Reserve, exercising its authority under the Home Ownership and Equity Protection Act of 1994, will propose new rules to address the subprime problems under its existing authority. The Fed is looking at curing a variety of practices, including penalties for prepayment, lack of escrow accounts, low-documentation lending, and inadequate borrower repayment abilities.

Given that many of the fraudulent originators have disappeared from the mortgage business, it makes sense to wait for new regulations from the Federal Reserve and other bank supervisory agencies rather than enacting major new legislation. We know we have a credit crisis — and we don’t want it to get worse.

Diana Furchtgott-Roth is a senior fellow at the Hudson Institute and former chief economist at the U.S. Department of Labor. She can be reached at dfr@hudson.org.