Cracks in subprime reaching higher-grade bonds

NEW YORK (Reuters) - Weakness in U.S. mortgage loans and the collapse of two Bear Stearns Cos. Inc. BSC.N hedge funds are raising worries that higher-rated debt may be the next to crumble.

The focus now is on so-called Alt-A loans, mortgages that fall between "prime" and "subprime" loans in quality.

Global financial markets have been roiled in recent weeks because the subprime crisis, triggered by troubled loans, is expanding to more sectors of the markets, impacting Wall Street earnings.

Moody's Investors Service is now reaching higher into Alt-A, or Alternative-A, loans in its review of potential downgrades, which may affect 66 groups of debt from residential mortgage-backed securities originated in 2005 and 2006, when aggressive underwriting led to problem loans increasingly at risk of default.

About half of those securities were issued by Countrywide Financial Corp. CFC.N and 13 were issued by Bear Stearns, according to Credit Suisse, which said the debt includes bonds rated from "A1," in the middle tier of high grade. The majority of the bonds are rated "Baa1" or lower; "Baa1" is three levels above junk.

Delinquency rates "are higher than original expectations," according to Moody's. The debt may "be insufficiently protected against the greater than anticipated losses implied by such high delinquency levels."

The rating company, which will make a decision within two months, may cut ratings on $318 million in debt securities, including Alt-A loans.

Asset-backed securities sold by Bear Stearns and IndyMac Bancorp Inc. IMB.N may be among those cut due to higher-than-expected delinquencies, Moody's said.

AAA VULNERABLE?

Bear Stearns' funds that bet heavily on risky subprime loans began to implode this spring and are now nearly worthless, the company told clients on Tuesday. For details, see ID:nN17260293.

T.J. Marta, a fixed-income strategist with RBC Capital Markets in New York, worries that the subprime problem could get even worse, affecting even top-rated AAA debt and hurting other hedge funds. Rating agencies last week cut ratings or began planning downgrades on billions of dollars of lower-rated subprime-related debt.

"Many customers are concerned that the Bear Stearns hedge fund implosion means AAA paper containing subprime exposure has collapsed," Marta wrote to clients on Wednesday. "The good news is that's not the case. The bad news is that's not the case yet."

More investors and overleveraged hedge funds could follow the same fate as the Bear Stearns funds, should rating companies begin to downgrade more high-grade debt.

"A vicious downward spiral could result," according to Marta.

Downgrades may seep into more Wall Street earnings. JPMorgan Chase & Co. (JPM.N) said on Wednesday it tripled the amount it set aside for loan losses as home equity borrowers missed payments, hurting the bank's second-quarter net income growth. For details, click on ID:nN18228229

The third-largest U.S. bank beat the average analysts' estimate, but the bank said it set aside $1.53 billion for loan losses, up from $493 million in the year-ago quarter. Much of that increase comes from higher loss estimates on home equity loans given to borrowers who put little money down.

FITCH RATINGS

Fitch Ratings sought to reassure clients on Wednesday and said that subprime mortgage bonds with the highest "AAA" rating have not eroded in quality despite recent price declines.

"We continue to be confident that "AAA" ratings reflect the high credit quality of those bonds," Glenn Costello, co-head of Fitch's residential mortgage group, said on a conference call.

Fitch, however, also said it will increase its assumptions of default on many subprime mortgages by as much as 150 percent.

So-called 2/28 loans, which a number of lenders have now stopped offering to homebuyers and that have fixed rates for two years and are adjustable thereafter, make up the bulk of the subprime mortgage market. Interest rates on many subprime loans can surge by 6 percentage points or more on the reset date, creating a payment shock that many analysts expect to worsen already high delinquency rates.

Fitch, Standard & Poor's and Moody's last week roiled debt markets by announcing downgrades or potential cuts to bonds and collateralized debt obligations backed by subprime loans.

S&P cut ratings on $6.4 billion of debt and Moody's downgraded $5.2 billion. Both now project losses for subprime loans originated in 2006 to reach as high as 14 percent, more than double the forecast in January.

(Additional reporting by Tim McLaughlin)