March 5 (Bloomberg) -- Lehman Brothers Holdings Inc. cut its investment rating on U.S. mortgage companies including Countrywide Financial Corp. because a surge in defaults may be spreading beyond the riskiest loans.

Lehman analyst Bruce Harting changed his recommendation for the so-called prime lenders to ``neutral'' from ``positive,'' and dropped Countrywide, the biggest U.S. mortgage lender, to ``equal weight'' from ``overweight.''

Missed payments on loans to the riskiest borrowers are rising as falling home prices make it hard to refinance adjustable-rate loans. New Century Financial Corp., an Irvine, California-based subprime lender, said March 2 it faces a criminal probe and may need credit extensions to stay in business. Fremont General Corp. plans to halt subprime lending.

``The rapid high-profile demise of the pure-play subprime lending industry has caused major, real dislocations in the market that should negatively impact the prime-oriented lenders' earnings over the course of 2007,'' Harting wrote in a research note to clients today. ``Prime loans will see rising default rates as subprime has, due to increasingly weak underwriting in recent vintages.''

Harting, the top-ranked mortgage finance analyst by Institutional Investor magazine in 2006, said he'd expected the Federal Reserve to cut short-term interest rates by now, sparking a wave of refinancing.

Late Payments

Countrywide, based in Calabasas, California, disclosed in a regulatory filing last week that payments were late on almost 20 percent of the subprime loans it manages for clients at the end of last year. Delinquencies in its conventional prime mortgages rose to 2.76 percent from 2.6 percent, while late prime home- equity loans increased to 2.93 percent from 1.57 percent.

Harting slashed his per-share earnings forecasts for Countrywide to $3.75 from $4.50 for this year, and to $4.25 from $5 for 2008. While credit in the company's prime portfolio won't get ``nearly as poor'' as in the subprime market, Countrywide's loan-loss provisions and defaults will likely continue growing as a percentage of total loans, he said.

The company's shares fell $1.82, or 4.9 percent, to $35.20 at 4:02 p.m. in New York Stock Exchange trading. They have declined 17 percent this year.

At least 20 subprime lenders have gone bankrupt, closed or sought buyers since the beginning of last year. Loan losses also spurred a management shakeup at the U.S. unit of HSBC Holdings Plc, Europe's biggest bank by market value.

Surprising Speed

``The rapidity, breadth and depth of the subprime sector meltdown has been extraordinary, even in the context of an environment in which most industry observers felt that major problems in the subprime space were inevitable and overdue,'' Harting wrote today.

Subprime mortgages carry rates at least 2 or 3 percentage points above the safest ``prime'' loans. They're given to people with poor or limited credit histories or high debt burdens. Such loans made up about a fifth of all new mortgages last year, the Washington-based Mortgage Bankers Association reported.

About 10.1 percent of subprime home loans included in securities were delinquent by 60 days, in foreclosure or already turned into seized property on Dec. 31. That's the most in at least seven years, according to a March 2 report from Friedman Billings Ramsey Group Inc.

The extra yield, or spread, that investors demand to own securities backed by subprime mortgage has surged this year. Spreads on typical BBB- rated bonds rose by 100 basis points last week to 450 basis points over the one-month London interbank offered rate, according to the estimates of Friedman Billings Ramsey Group. A basis points is 0.01 percentage point.

Harting said the erosion in profit margins that subprime lenders get from selling loans to investors ``could pressure'' margins in prime loans as well.

To contact the reporter on this story: Will Edwards in Charlotte, North Carolina, at wiedwards@bloomberg.net.

Last Updated: March 5, 2007 16:28 EST