April 24 (Bloomberg) -- Bond investors who financed the U.S. housing boom are starting to pay the price for slumping home values and record delinquencies in subprime loans.

They will lose as much as $75 billion on securities made up of millions of mortgages to people with poor credit, says Pacific Investment Management Co., manager of the world's biggest bond fund. Some of the $450 billion in subprime mortgage-backed debt sold last year has lost 37 percent, according to Merrill Lynch & Co.

BlackRock Inc., AllianceBernstein Holding LP and Franklin Templeton Investments are vulnerable because investors have replaced banks and thrifts as the primary source of money for U.S. mortgages. More than $6 trillion of mortgage bonds are outstanding, dwarfing the amount of U.S. government debt by about 50 percent.

``Bond investors will be the ones who will take the losses,'' not the banks, said Scott Simon, who oversees $250 billion in asset-backed securities at Newport Beach, California- based Pimco, a unit of insurer Allianz SE in Munich.

Investors are losing money because of places like Riverside County, California, where foreclosures almost tripled last quarter to 6,103 from a year earlier, the biggest increase in the U.S., according to Foreclosures.com.

Lehman Brothers Holdings Inc., the fourth-largest U.S. securities firm, used Riverside loans as collateral for $1.5 billion of bonds sold in January 2006. Some of the lowest-rated portions of the securities trade at 63 cents on the dollar, down from more than 100 cents in October, according to data compiled by Merrill Lynch.

BlackRock, Franklin Templeton

Investors in the Lehman bonds include New York-based BlackRock, which oversees $1 trillion of assets and AllianceBernstein, which manages $726 billion, according to filings with the Securities and Exchange Commission. Franklin Templeton, a San Mateo, California-based firm that oversees $565 billion, also bought the bonds, data compiled by Bloomberg show.

Bond investors paid for the decade-long real estate expansion that led to a record 69 percent of Americans owning their own houses.

Home buyers were able to get loans from banks, thrifts and mortgage companies who would then typically sell them to underwriters, freeing up cash for more lending. New York-based Lehman; Bear Stearns Cos., the biggest underwriter of mortgage bonds; Morgan Stanley, Wall Street's biggest real estate investor, and other securities firms packaged loans into bonds and then sold them.

`More Lenient'

About two-thirds of mortgages get turned into bonds, up from 40 percent in 1990, when the market was $1.08 trillion and the country suffered its last real estate slump, according to data from the Federal Reserve and Fannie Mae in Washington.

Mortgage companies increased the amount of loans they provided when the economy was accelerating by accepting home buyers who previously couldn't obtain credit. These subprime mortgages totaled almost 20 percent of all new home loans last year, according to the Mortgage Bankers Association, a Washington-based trade group.

When U.S. growth slowed and home prices stopped rising last year, delinquencies mounted. About 13 percent of subprime mortgages made in 2006 were delinquent after 12 months, with 6.65 percent considered ``seriously delinquent,'' or more than 90 days late, Standard & Poor's estimates.

``Underwriter standards have gotten progressively more lenient,'' said Mark Tecotzky, chief investment officer at Greenwich, Connecticut-based Ellington Management Group LLC, a $4 billion hedge fund that invests in mortgage bonds.

`Feet to the Fire'

Bondholders are as much to blame as lenders, Federal Deposit Insurance Corp. Chairwoman Sheila Bair in Washington says.

``We should hold the servicers' and the investors' feet to the fire on this,'' Bair said in testimony to the House Financial Services Committee last week. ``We did not have good market discipline with investors buying all these mortgages.''

Barney Frank, a Democrat from Massachusetts and chairman of the House Financial Services Committee, and Spencer Bachus of Alabama, the top Republican on the committee, said earlier this month that they favor legislation making bond investors liable for loans that end up in default.

`Attractive Yield'

Investors say more regulation may dry up financing for homes, causing more delinquencies and damaging the economy. The National Association of Realtors in Washington said today that sales of previously owned U.S. homes declined 8.4 percent in March to an annual rate of 6.12 million, the lowest level in almost four years.

The bond market has reduced ``the cost of mortgage credit by linking investors and home-buying families through mortgage securitization,'' said George Miller, executive director for American Securitization Forum, an industry trade group for investors and underwriters in New York. Miller made the comments last week in testimony to the House Financial Services Committee.

Roger Bayston, director of fixed income at Franklin Templeton, which bought $800,000 of the Lehman bonds, said his firm hasn't lost money because it purchased the highest-rated portions of the securities. He would buy them again, he said.

BlackRock bought the portion of the SAIL 2006-1 bonds rated AAA and due in six months because ``it offered an attractive yield relative to similar securities,'' said Aaron Read, fixed- income portfolio manager at the firm.

The AAA rated part pays 8 basis points more than the London interbank offered rate in yield while securities based on credit- card payments and with the same ratings pay about 2 basis points or 3 basis points less than Libor, Read said. A basis point is 0.01 percentage point.

Contained

``The advantage of the asset-backed structure is that it passes the credit risk to the lower-rated tranches and insulates the AAA classes from losses,'' Read said.

AllianceBernstein spokeswoman Stephanie Giaramita didn't return calls seeking comment. Pimco's Simon said his firm is also only buying the highest-rated parts of mortgage bonds.

The losses in mortgage bonds haven't spread to other markets, even though more than 50 lenders have halted operations, gone bankrupt or sought buyers since the start of 2006, according to Bloomberg data. Defaults on subprime mortgages tracked by the Mortgage Bankers Association surged to a four-year high in the fourth quarter.

``The economic risk, the macro risk -- I don't see it posing a serious problem,'' U.S. Treasury Secretary Henry Paulson said after a speech in New York on April 20 in response to questions on the collapse of the subprime mortgage market.

Brown Grass

Driving around Riverside County's Lake Elsinore, realtor Abdul Syed counts about 40 lots with brown grass in the 1,200- home Tuscany Hills subdivision. Owners stop watering their lawns when they are about to lose their homes, he said.

``All of these people are probably in default and probably going to face foreclosure really soon,'' said Syed, who in 2002 moved to the town of 38,000 about 60 miles from San Diego.

The owner of 16 Ponte Russo paid $650,000 for the Mission- style house in November 2005 and got financing for 100 percent of the price from BNC Mortgage Inc. in Irvine, California, according to country records. BNC is a subprime lender owned by Lehman.

The owner never made mortgage payments. Now, the house is on sale for $496,000 following a foreclosure. Attempts to reach the owner weren't successful.

That house is ``a real nice one because it backs up into a canyon and you have endless views of hills,'' Syed said. ``That's a great deal. The banks must be getting kind of desperate.''

Rates Reset

More than 43 percent of the bonds sold by Lehman, called SAIL 2006-1, are based on property in California. Foreclosures in the state have quadrupled since September to $2 billion, according to Foreclosure Radar in Sacramento. SAIL stands for Structured Asset Investment Loan Trust.

The SAIL bonds were backed by 7,600 mortgages when they were issued. Almost $50 million of the loans are in foreclosure, some $25 million are 90 days delinquent and banks have seized property backing $30 million more, according to data compiled by Bloomberg.

The bonds are one of only six to ever be downgraded before their first anniversary, and the biggest of that group, S&P said. Coupons range from 5.4 percent for the highest-rated portions to 7.82 percent for the lowest-rated pieces.

Rates on almost half of the loans in the Lehman bonds are scheduled to increase to an average 10.3 percent in December from about 7 percent now, according to the prospectus for the securities.

Fees

David Sherr, the managing director in charge of global securitized products at Lehman, and Steven Skolnik, chief executive officer of BNC, declined to comment.

Packaging mortgages into bonds has been the fastest-growing part of the debt market since 1995, providing investors with securities and a default rate below 1 percent.

Fees from securitizing assets like mortgages and student loans almost tripled in the past five years to $5.6 billion, Bank of America Corp. analyst Michael Hecht in New York estimated. Like Lehman, underwriters including Bear Stearns, Merrill Lynch and Morgan Stanley bought lenders to gain access to a steady supply of loans.

Much of the demand for the mortgage bonds came from Europe and Asia, where investors borrowed in their currencies and used the proceeds to buy higher-yielding assets in America. The Fed holds $675 billion of mortgage bonds and debt sold by Fannie Mae and Freddie Mac -- the two biggest financiers of home loans --on behalf of foreign central banks and international accounts, an eightfold increase this decade.

Demand Jumps

Demand for high-yielding mortgage bonds jumped after the Fed in 2003 cut its target interest rate for overnight loans between banks to a 45-year low of 1 percent. Subprime mortgages typically have rates at least 2 percentage points or 3 percentage points above safer prime loans.

Subprime mortgage bond sales grew to $450 billion last year from $95 billion in 2001, according to the Securities Industry Financial Markets Association, a New York-based industry trade group. The amount of mortgage bonds outstanding increased 82 percent over that period.

``More money was being lent than should have been lent,'' Congressman Frank said in an interview. Mortgage bond investors ``provided liquidity without responsibility,'' he said.

Subprime mortgage-backed securities from 2006 may be the worst ever, with delinquencies on the underlying debt ``consistently higher'' than in the prior five years, according to S&P. Losses on loans backing bonds will be between 5.25 percent and 7.75 percent, S&P said.

Losing Homes

As many as 2.4 million Americans may lose their homes, the Center for Responsible Lending in Durham, North Carolina said in testimony to Congress last month. The National Association of Realtors this month said the median price for an existing home likely will fall 0.7 percent to $220,300 this year, the first annual drop since the trade group began keeping records in 1968 and probably the first decline since the Great Depression.

Foreclosures in California will rise to 70,000 in 2008 from 3,000 in 2005, said Bruce Norris, a resident of Riverside, California, who buys houses in foreclosure.

``There is no way this is going to play out without pain,'' Norris said. ``It's already not OK. It just hasn't hit the courthouse steps.''

To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net.

Last Updated: April 24, 2007 13:52 EDT