by Calculated Risk on 12/06/2005 11:46:00 AM

Bloomberg reports: Housing Bubble Bursts in U.S. Mortgage Bond Market

Bonds backed by home loans to the riskiest borrowers, the fastest growing part of the $7.6 trillion mortgage market, have lost about 2.5 percent since September on concern an 18-month rise in interest rates may force more than 150,000 consumers to default.

``We've been hearing about risks of a house price bubble, easy credit and loans to borrowers that really don't qualify, and now in the last couple of months we're starting to see things turn for the worse,'' said Joseph Auth, a bond fund manager who helps oversee $135 billion at Standish Mellon Asset Management in Boston. ``We don't know if it's going to be a hard or soft landing.''
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The slump in the bonds is one of the first signs the housing boom is ending after the Federal Reserve's 12 interest- rate increases. Real estate has accounted for about half the economy's growth since 2001, according to Merrill Lynch & Co.
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About 13.4 percent of all mortgages at the end of June were to borrowers considered most likely to default, such as those with high credit card balances, up from 2.4 percent in 1998, according to the Mortgage Bankers Association. The Washington- based trade group's 2,700 members represent 70 percent of the home-loan business.

The amount of bonds backed by these high-risk loans has more than doubled since 2001, to a record $476 billion, according to the Bond Market Association, a New York-based trade group of more than 200 securities firms.

The market ``will deteriorate as housing slows down,'' said Christopher Flanagan, who runs asset-backed debt research at New York-based JPMorgan Chase & Co., the fourth-largest mortgage lender in the U.S. The amount of loans made next year may fall by as much as 25 percent, he said.
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The last time delinquency rates on lower-rated mortgages jumped was in 2000 as economic growth slumped following the Fed's six rate increases. The central bank has lifted rates 12 times since June 2004, to 4 percent from 1 percent.
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Delinquencies tend to peak two to three years after subprime loans are originated, said Glenn Costello, an analyst at Fitch Ratings in New York. Peak rates of about 20 percent to 25 percent now will likely rise to the high-20s in 2006, he said.
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Lenders that rushed to provide mortgages amid rising home prices are now stuck with loans worth less than they expected because bond investors are demanding more protection. They are raising mortgage rates help to make up the difference.
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``In a rapidly changing environment, you can find yourself ahead or behind the yield curve,'' Robert Cole, chief executive officer of New Century, the No. 2 lender to people with the lowest credit scores, said in a Nov. 15 interview in New York. ``With rates going up, it's more likely behind.''

This is really no surprise. Many marginal buyers used excessive leverage (a type of speculation) to purchase a home. They were hoping that continued home price appreciation would bail them out, if their personal financial situation did not improve.

Even if home prices just flatten out, many of these marginal buyers will be in trouble. And the mortgage bond market is reflecting that fear.