Nov. 12 (Bloomberg) -- Residential and commercial-mortgage backed bonds tumbled after Treasury Secretary Henry Paulson said the government no longer plans to buy devalued mortgage assets, credit-default swap indexes suggest.

All 24 of the ABX indexes tied to subprime mortgage bonds fell to new lows, according to Markit Group Ltd. One of them, known as ABX-HE-PENAAA 07-2 linked to AAA rated bonds created in the first half of 2007, dropped 8.4 percent to 41.83. The level suggests the bonds might fetch about 42 cents for each dollar of balances.

Paulson's decision follows announcements of different plans by JPMorgan Chase & Co. and Citigroup Inc., two of the country's largest banks, and Fannie Mae and Freddie Mac, the largest mortgage-finance companies, to rework bad mortgages. The government's exit as a potential buyer added to confusion that's deterring investors in the bonds.

``No one in the market knows what to believe any more,'' David Castillo, a senior trader of structured-finance bonds at Further Lane Securities in San Francisco, said in an e-mail today. ``Things change on a daily basis.''

Non-agency home-loan bonds, which rallied ahead of the creation of a $700 billion financial rescue program last month, had already returned to setting new lows as the credit-market slump broadened; data signaled a weakening U.S. economy; Paulson spent funds on capital injections into banks; and concern grew that foreclosure-prevention efforts may boost losses, in part by encouraging more defaults.

Consumer Credit Relief

The second half of the program will be used to help relieve consumer credit, not buy mortgages and related bonds, Paulson said today in a speech. Treasury and Federal Reserve officials are exploring a new ``facility'' aimed at bolstering the market for securities backed by assets other than mortgages, he said.

Spreads on AAA commercial mortgage-backed securities today soared 71 basis points to a record 714.5 basis points more than the benchmark swap rate, according to Bank of America Corp. data. The bonds were trading at 582 basis points over the benchmark a week ago. A basis point is 0.01 percentage point.

The Securities Industry and Financial Markets Association is ``disappointed Treasury is choosing to de-emphasize the asset purchase portion of the TARP program,'' Tim Ryan, the New York- based group's chief executive officer, said in a statement today. ``A key ingredient to a strong recovery is the creation of price discovery through some type of transparent purchase program.''

Loan-Modification Plans

Legislation is needed to restructure U.S. mortgage servicing contracts to make it easier for lenders to modify loans for homeowners struggling to avoid foreclosure, House Financial Services Committee Chairman Barney Frank said today said at a hearing in Washington.

``Uncertainty in investors' minds'' about what types of new loan-modification plans servicers will adopt have also been a drag on prices simply because it makes it harder to value the debt, said Scott Eichel, co-head of asset-backed and mortgage trading at RBS Greenwich Capital.

Non-agency mortgage bonds lack guarantees from Fannie Mae and Freddie Mac, the mortgage-finance companies seized by the U.S. in September, or federal agency Ginnie Mae.

So-called ABX and CMBX indexes have been suggesting higher prices than investors can get for actual bonds. Bonds similar to those tracked by ABX-HE-PENAAA 07-2 have been trading between 30 and 40 cents on the dollar, so declines in swap indexes after Paulson's announcement may not mean that drops will be as steep for bonds, said Eichel, who's based in Greenwich, Connecticut.

``For the last couple of weeks I don't think a lot of people thought they were going to buy a lot of mortgage assets,'' he added in a telephone interview today.

TARP Buying

Buying for the so-called Troubled Asset Relief Program had already appeared likely to focus mostly on mortgages rather than mortgage bonds because the U.S. could more easily use loan purchases to rework bad debt and stem sliding home prices, according to Thomas Hamilton, head of asset-, mortgage- and commercial-mortgage-backed securities at Barclays Capital Inc.

Buying of unsecuritized loans ``probably makes a lot more sense for this program, as much as that doesn't work for me,'' he said at conference in New York on Nov. 10. ``I'd much rather have them purchase securities'' and boost their prices.

While Paulson said today that buying mortgage-related assets is ``not the most effective way to use TARP funds,'' he added that the new plan ``may also be used to support new commercial and residential mortgage-backed securities lending'' and the U.S. may make ``targeted'' asset purchase.

``Paulson reminds me of a little kid pulling some half- chewed piece of gum out of his pocket to fix the house falling down around his parent's ears, and offering it to his Dad with great excitement,'' said Eric Boughton, a portfolio manager at Deschutes Investment Advisors in Portland, Oregon, which oversees $1 billion.

``Then he gets tired of trying to fix the house, goes out to play for a little bit, and eventually comes back in with a ball of old string and asks if it'll help with the delinquent credit- card notice his Mom is poring over.''

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

Last Updated: November 12, 2008 17:22 EST