Nov. 13 (Bloomberg) -- Mortgage bonds tumbled for a second day after Treasury Secretary Henry Paulson scrapped plans to buy devalued mortgage assets, credit-default-swap indexes suggest.

All 24 ABX indexes tied to subprime mortgage securities fell to new lows, including the ABX-HE-PENAAA 07-2 linked to AAA rated bonds created in the first half of 2007. The index fell 6.2 percent to 39.21, according to Markit Group Ltd. The level of the index, which has dropped 14 percent this week, indicates the bonds might fetch about 39 cents per dollar of balances.

Paulson yesterday said mortgage-asset purchases wouldn't be ``the most effective way to use'' funds remaining from the $700 billion Troubled Asset Relief Program, or TARP. Potential sellers of mortgage bonds who were anticipating higher government bids are now off-loading debt, said Sean Kirk, a trader of structured- finance bonds at New York-based Seaport Group LLC.

``For a lot of people that was the last hope,'' Kirk said in a telephone interview today.

Non-agency home-loan bonds, which rallied ahead of the creation of the TARP last month, had already returned to their 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, partly by encouraging more defaults.

Paulson's public reversal had the effect of ``crushing people's confidence,'' even though many investors and traders in recent weeks had already come to believe it was unlikely the U.S. would buy assets, said Jim Shallcross, director of portfolio management at Declaration Management & Research LLC.

``At some point, finance is just a huge game of trust, confidence and reliability and it's not going well in that regard,'' said Shallcross, whose McLean, Virginia-based firm manages about $14 billion in fixed-income assets.

Commercial Mortgage Bonds

Securities backed by commercial mortgages also crumbled over the past two days.

Yields on top-rated commercial-mortgage securities rose 75 basis points to a record 790 basis points more than the benchmark swap rate, according to data from Bank of America Corp. A basis point is 0.01 percentage point.

Paulson's decision wasn't surprising because it had become clear that there's not a liquidity crisis but a ``severe solvency crisis in the banking system'' David Leduc, a global strategist for fixed income at Boston-based Standish Mellon Asset Management, said in a Bloomberg Television interview today.

``If you look at past banking crises, either in Japan or the Nordic banking crisis of the 90s, the ultimate solution was for governments to get involved and actually provide capital'' to financial firms, said Leduc, whose division of New York Mellon Corp.'s asset management unit oversees $187 billion.

Agency Bonds

The $2 trillion of non-agency U.S. home-loan 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.

Spreads on the almost $5 trillion of agency mortgage bonds narrowed today as the Treasury disclosed it bought $21.5 billion of Fannie and Freddie securities last month, up from $5.1 billion in the first month of a program to buy their home-loan bonds to support mortgage rates.

The difference between yields on Washington-based Fannie's current-coupon 30-year fixed-rate mortgage securities and 10-year Treasuries fell about 9 basis points to about 172 basis points as of 4:10 p.m. in New York, the lowest since Oct. 21, according to data compiled by Bloomberg show.

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

Last Updated: November 13, 2008 16:49 EST