Freddie Mac subprime twist fuels credit crunch talk

NEW YORK Wed Feb 28, 2007 7:14am EST

NEW YORK (Reuters) - The planned boycott of some of the most popular subprime mortgages by No. 2 mortgage buyer Freddie Mac is the latest sign of a broad risk-aversion trade spreading across financial markets.

Investors are taking the move by Freddie Mac -- one of the biggest buyers of subprime debt with $180 billion held -- on Tuesday as a no-confidence vote on so-called 2-28 mortgages that comprise three-quarters of the industry. It may be a blow to the market already struggling with an unexpectedly sharp rise in delinquencies and investor panic.

"This will add to the subprime pullback" that already hurt the availability of money in the market, said S.A. Ibrahim, chief executive officer at risk management and mortgage insurer Radian Group Inc. (RDN.N) "This is the long-awaited widening in credit spreads we have all been waiting for in an environment where we thought credit spreads were too cheap."

Lenders, cashing in on the U.S. housing boom, had been encouraged to loosen underwriting standards to boost volumes by soaring demand from Wall Street and other investors. The rapid price appreciation of the past five years kept delinquencies near record lows in such mortgages since the borrower could refinance and monetize the newfound house value.

Delinquency rates on subprime loans almost tripled in the two years through December, to nearly 7 percent, according to Lehman Brothers data. Reports on loans this month suggest no improvement, a fund manager said.

With delinquencies now outpacing forecasts, Freddie Mac said it would only buy portions of subprime mortgages given to borrowers who proved they could shoulder an increase in their mortgage rate, which could be as much as 6 percentage points. Most lenders qualify borrowers for 2-28 loans at the initial two-year fixed rate instead of the rate that adjusts each of the final 28 years.

Freddie Mac's decision is "feeding into a market where a lot of originators are saying they are going to tighten their lending standards," said Janet Braggs, senior vice president of fixed income research at Dwight Asset Management in Burlington, Vermont. "One could potentially see a credit crunch which could obviously, for any market, have significant ramifications."

The fact that lenders started making more creditworthy loans months ago softens the impact of Freddie Mac's move, said Bob Napoli, an analyst at Piper Jaffray & Co. in Minneapolis. Freddie Mac also purchases the top, AAA-rated portions of bond issues that are in highest demand by other investors, he said.

"A year ago this would have been a really big deal but there's been massive tightening," he said. "A year ago this might have cut out 35 percent of the market and now under current guidelines, about 15 percent."

Shares of mortgage lenders outperformed the broader stock market that suffered its worst one-day fall in almost four years. Subprime lender New Century Financial Corp.'s NEW.N stock fell 25 cents, or 1.64 percent, to $14.99.

Major U.S. stock indexes were down more than 3 percent.

Freddie Mac said it will implement its new investment requirements on or after September 1 to "avoid market disruptions." The McLean, Virginia-based company will introduce a series of its own subprime loan products that lenders can offer and that will limit delinquencies.

Daniel Mudd, chief executive of Washington-based rival Fannie Mae, said the company wants to play a larger role in financing subprime mortgages but pricing on the loans has been too aggressive for the degree of risk.

Signs even diversified financial companies including Washington Mutual Inc. (WM.N) were surprised by delinquencies have sent a portion of the $575 billion subprime bond market into a downward spiral. An index corresponding to the lowest-rated subprime bonds has dropped more than 30 percent this year and eroded more on Tuesday after Freddie Mac raised fears of a credit crunch that could reverberate through the entire $10 trillion U.S. mortgage market.

The movement to tighten credit is also on the minds of regulators and lawmakers who are studying whether to hold lenders to the same standards that have pinched sales of so-called "affordability loans" to prime borrowers.

Moves to restrict credit are contributing to the broad trade in global financial markets on Tuesday as investors pare risk in many asset classes including emerging markets, said Jason Brady, who helps manage $4 billion in bonds at Thornburg Investment Management Inc. in Santa Fe, New Mexico.

Investors on Tuesday are flocking to the perceived safety of U.S. Treasuries and fleeing stocks amid concern that demand from China, the world's most populous nation, will pull back on demand for U.S. goods and services. Concern of slower U.S. growth were heightened after a report on Tuesday showed orders for durable goods plummeted 7.8 percent in January.

"It's risk aversion on a wider scale at this point," Brady said in an e-mail.

(Additional reporting by Nancy Leinfuss in New York and Patrick Rucker in Washington)