July 24, 2007 / 10:18 PM / 10 years ago

Subprime mortgage bond market in deep freeze

NEW YORK (Reuters) - Sales of bonds that finance the $1.2 trillion U.S. subprime home loan market have ground to a halt, as delinquencies by borrowers continue to rise and credit rating agencies downgrade the securities.

A lending slowdown in a housing market that is already seeing lower average home prices across the U.S. may spill over into a broader credit crunch and slow economic growth further.

At the heart of problem are borrower defaults on adjustable-rate mortgages (ARMs) as scheduled interest rate increases of as much as 6 percentage points take effect, creating a “payment shock” for home loan borrowers.

In addition, credit rating agencies including Moody’s Investors Services also raised forecasts for losses on new bonds, resulting in Wall Street banks choosing to freeze deals in their tracks.

“Moody’s and Standard & Poor’s finally got it into gear, downgrading hundreds of subprime issues and threatening more to come,” Bill Gross, manager of the world’s biggest bond mutual fund at Newport Beach, California-based Pacific Investment Management Co., said on the PIMCO Web site on Tuesday.

Only two subprime ARM-backed bonds have been sold in the first three weeks of July, compared with at least a dozen subprime ARM deals in the last week of June alone, according to JPMorgan. Closely held issuers C-BASS and Bayview Financial were the lone sellers of relatively small deals this month.

Rates on $335 billion in subprime ARMs are due to reset in the next 12 months, according to Fitch Ratings and Loan Performance data. The time is also near for borrowers who opted for temporary savings available in interest-only (IO) loans.

“When these loans reset, IO periods are over, what makes you think thing are going to go favorably?” said Evergreen’s Morrison. “So the (new issue) market is kind of frozen.”

Issuance in home-equity asset backed securities, mostly made up mostly of subprime bonds, was $199 billion through July 20, down about 37 percent from the same period in 2006, JPMorgan data showed.

Price indexes for subprime mortgage bonds are at record lows. The ABX-HE “AAA” 07-1 index, which tracks bonds deemed to have the least exposure to loss, slumped earlier this month, dropping from the near-perfect level of 99.5 to about 95.

”Rating actions caught the attention of investors who thought that if you bought a ‘AAA’ rated bond“ that it would stay ‘AAA,'” said Darcy Morrison, an analyst at Evergreen Investments in Charlotte, North Carolina. “Who knew it could get dinged as bad as it was.”

So far this year, 662 subprime securities valued at a combined $23.6 billion have been downgraded by U.S. credit rating agencies. Of that amount, $4.7 billion of subprime residential mortgage-backed securities, have been cut to junk-bond status from investment grade, according to Deutsche Bank.

    Speculation of further downgrades on bonds back by both subprime loans and loans to so-called Alt-A borrowers with better credit, has also reduced demand for the investment vehicles known as collateralized debt obligations (CDOs) which invest in a range of bonds with different credit risks.

    Meanwhile, lower-quality ABX indexes have lost more than half their value this year.

    The market for new subprime bonds “has practically ceased activity” because of the ABX sell-off and wider spreads on the underlying bonds, said Christopher Flanagan, head of ABS research at JPMorgan Securities in New York.

    The seizure of the market that has been blamed for easy and excessive credit in the U.S. housing market will be felt beyond the marbled halls of Wall Street banks whose record profits in recent years have been fueled by the origination, packaging and trading of subprime bonds, analysts said.

    Big lenders including Countrywide Financial Corp. CFC.N and Wells Fargo & Co. (WFC.N) have stopped offering some subprime ARMs that customers with low credit scores may rely on to save their homes. Some 40 percent of borrowers may no longer be able to refinance before their ARMs reset to higher interest rates, Flanagan wrote in a note.

    Countrywide’s head, Angelo Mozilo, on Tuesday gave a dire assessment of the U.S. housing market as his company lowered its earnings outlook. He said the housing recovery may not be felt until 2009, matching a similar assessment by home builder KB Home (KBH.N) last week.

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