Dec. 7 (Bloomberg) -- President George W. Bush's plan to freeze interest rates on some subprime mortgages may prove to be a cure that breeds another disease.

``If the government goes in and changes contracts it will definitely have a chilling effect on the securitization of mortgages,'' said Milton Ezrati, senior economist and market strategist at Lord Abbett & Co. in Jersey City, New Jersey, which oversees $120 billion in assets. ``When the government comes in and says you have contracted to have this arrangement and you can no longer have it, I think it opens the door for lawsuits.''

Bush and Treasury Secretary Henry Paulson yesterday announced an agreement with lenders that will fix rates on some loans for five years. The deal will help borrowers who will fall behind once rates reset to higher levels through July 2010. The plan may force investors in the $6.3 trillion market for home- loan bonds, created by pooling loans and funneling interest payments to bondholders, to revalue their holdings.

``It could end up there's less confidence in the viability in the bond markets and the mortgage markets going forward and it could lead to higher interest rates and higher mortgage rates for everybody,'' said Kenneth Hackel, managing director of fixed- income strategy at RBS Greenwich Capital Markets.

Hackel said in an interview from his Greenwich, Connecticut, office that he has been ``fielding a lot of calls'' from clients ``pounding the tables and beating the drums.''

Existing Contracts

``I've never seen anything such as they're suggesting here in my career,'' said Lord Abbett's Ezrati, who has worked in finance for 36 years. ``It would be the equivalent of telling you the coupon on a bond is being changed.''

The American Securitization Forum, the New York-based industry group that worked with regulators to forge the deal, said Bush's plan is designed to work within the existing contracts. As part of a typical bond contract, servicers are required to modify loans only when it would yield more cash to debtholders than a foreclosure. Agreements also state that loans can't be modified unless a default is ``reasonably foreseeable.''

``We do not think it is hyperbolic to say that the sanctity of such contracts, entered into in good faith, is at the cornerstone of capitalism,'' Deutsche Bank AG analysts Karen Weaver, Katie Reeves and Ying Shen, based in New York, said in a note to clients today. ``And if we are to in anyway devalue that sanctity, we face a far greater liquidity crunch than the one in which we currently find ourselves.''

Best Interests

Servicers will be acting in the best interest of bond investors because foreclosures would cause greater losses, the ASF said in a statement yesterday. The ASF cautioned servicers against modifying more loans than allowed under some contracts.

``The initial reaction of a lot of people including myself a week ago would have been, `Hey this isn't fair,''' said Andrew Harding, chief investment officer for fixed income at Allegiant Asset Management in Cleveland, which manages $18 billion. ``It isn't fair but it most likely is in the best interest of both those who are making payments and those who can't make higher payments.''

Mortgage securities and leveraged loans have already caused $66 billion of losses at the world's banks. Goldman Sachs Group Inc. estimated last month that losses in credit markets worldwide may reach $726 billion.

Foreclosures almost doubled in October from a year earlier as borrowers with poor credit failed to make higher payments, Irvine, California-based RealtyTrac Inc. said Nov. 29. Credit Suisse Group analysts project 775,000 homes with $143 billion of mortgage debt will go into foreclosure in the next two years.

Ratings Cuts

Bush's three-pronged plan calls for freezing rates or refinancing into either a new private mortgage or a Federal Housing Administration-backed loan. As many as 1.2 million subprime mortgages paying adjustable rates will be eligible for assistance under the plan, or about two-thirds of the 1.8 million subprime owner-occupiers facing a reset.

Standard & Poor's said yesterday that freezing rates on subprime mortgage loans may lead to credit-rating reductions on some mortgage bonds. The government's plan may shrink the difference between interest payments received from home loans and the interest due to bondholders, S&P said in a report.

Bush's plan may be shaking confidence in the bond market while actually doing little to help borrowers.

The ``fast track'' option for an automatic five-year interest rate freeze for some borrowers may help as few as 90,000 homeowners, not enough to send bond prices lower, Deutsche Bank said. The qualifying loans will be ``so low as to have a negligible impact on bond performance,'' the analysts wrote.

`Lose/Lose'

``We have a voluntary program that is mostly smoke and mirrors and probably won't freeze enough mortgages to make a difference, but the bond market is reacting negatively, which will make it harder to sell mortgage backed securities,'' Bob Yopko, president of Chelsea, Michigan-based First Equity Residential Mortgage Inc., wrote in an e-mail today. ``A lose/lose proposition.''

The plan makes investors in low-rated and unrated bonds ``winners'' while bondholders of higher-rated securities will have their risks increase, said Andrew Chow, who manages $7 billion in asset-backed bonds at SCM Advisors LLC in San Francisco.

Owners of ``residuals,'' the unrated pieces of deals, are the first to have their interest end when homeowners can't meet their mortgage payments.

`Guesstimates'

The plan may end up increasing losses for senior debtholders if home prices continue to decline and the borrowers end up defaulting, Chow said. Without the plan, those holders may have faced only ``modest'' losses, he said.

Freezing rates is a ``net negative'' for bond investors, mortgage originators and bond insurers, RBC Capital Markets analyst Hank Calenti in London said in a report dated today.

``Now investors must guesstimate the likelihood of and the probable amount of confiscated excess interest in the RMBS collateral pool, in addition to the multitude of other inputs to the pricing model,'' Calenti said. ``This increases the uncertainty of the total expected cash flows over time.''

To contact the reporters on this story: Caroline Salas in New York at csalas1@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net

Last Updated: December 7, 2007 13:14 EST