Cornered banks drop bread-and-butter subprime loans

By Al Yoon - Analysis

NEW YORK (Reuters) - U.S. lenders' decision to abandon their most popular subprime mortgages in favor of less risky loans represents their most draconian move yet to stanch losses.

The mortgages, known as 2/28s, produced last year are turning out to be among the worst home loans ever made as record numbers are going delinquent within months. The loans made up 65 percent of subprime volume in 2006, making them a key ingredient for profit during the housing boom.

The shift by lenders, including Washington Mutual Inc. WM.N and Countrywide Financial Corp. CFC.N, is changing the face of the subprime business, which has grown to about 14 percent of the more than $10 trillion U.S. mortgage market from less than 3 percent in 1998.

Losing the product will likely exacerbate the shrinkage of the market, whose volumes have already contracted by a third this year, industry watchers said.

"They are really going to the other side with the pendulum," said Bob Moulton, president of Americana Mortgage, a Manhasset, New York-based broker.

The 2/28 loan carries a fixed rate for two years before adjusting higher biannually in the following 28. The interest rate on loans can rise 6 percentage points or more at reset.

The loans -- dubbed subprime "bread and butter" by analysts at the investment bank Credit Suisse -- have been popular with lenders that typically encourage borrowers to refinance before rates change, perhaps to a prime loan as their credit improves.

With the shift by Washington Mutual (WaMu) to 5/25 loans, borrowers have a longer time to repair credit, helping buoy overall loan quality, said David Schneider, president of the Seattle-based lender's loan unit.

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Lenders have been encouraged to reduce or cut the offering of 2/28s by stricter lending guidance from regulators.

The new guidance urges lenders to show that customers can make higher monthly payments once the loan resets to a higher rate. Previously, borrowers only had to demonstrate that they could meet payments set according to lower initial rates.

At Countrywide, nearly 60 percent of borrowers with subprime adjustable rate mortgages would not have qualified in the last quarter of 2006 if the federal guidelines had been followed.

Lenders abandoned their 2/28 programs one after another in a matter of days after rating agencies announced hundreds of bond issue downgrades tied to these subprime loans and tightened credit requirements last week.

Other lenders making the move included H&R Block Inc.'s (HRB.N) Option One Mortgage, Merrill Lynch & Co.'s MER.N First Franklin and Accredited Home Lenders Inc. LEND.O.

"The alteration of loan products was put into high gear in terms of timing and magnitude of change as the rating agencies tightened their criteria," said Sharon Greenberg, a bond analyst at Credit Suisse in New York.