Dec. 6 (Bloomberg) -- In the U.S. bond market, the housing bubble has burst.

Bonds backed by home loans to the riskiest borrowers, the fastest growing part of the $7.6 trillion mortgage market, have lost about 2.5 percent since September on concern an 18-month rise in interest rates may force more than 150,000 consumers to default.

``We've been hearing about risks of a house price bubble, easy credit and loans to borrowers that really don't qualify, and now in the last couple of months we're starting to see things turn for the worse,'' said Joseph Auth, a bond fund manager who helps oversee $135 billion at Standish Mellon Asset Management in Boston. ``We don't know if it's going to be a hard or soft landing.''

Mortgage securities with low ratings and loans from Ameriquest Mortgage Co. and New Century Financial Corp., two Irvine, California-based companies that specialize in lending to the 50 million people with histories of late payments and bankruptcies, yield the most in two years. The rise in yields reduced the value of loans made by lenders, resulting in lower profit margins and higher rates for consumers with bad credit.

The slump in the bonds is one of the first signs the housing boom is ending after the Federal Reserve's 12 interest-rate increases. Real estate has accounted for about half the economy's growth since 2001, according to Merrill Lynch & Co.

Growing Market

About 13.4 percent of all mortgages at the end of June were to borrowers considered most likely to default, such as those with high credit card balances, up from 2.4 percent in 1998, according to the Mortgage Bankers Association. The Washington- based trade group's 2,700 members represent 70 percent of the home-loan business.

The amount of bonds backed by these high-risk loans has more than doubled since 2001, to a record $476 billion, according to the Bond Market Association, a New York-based trade group of more than 200 securities firms.

The market ``will deteriorate as housing slows down,'' said Christopher Flanagan, who runs asset-backed debt research at New York-based JPMorgan Chase & Co., the fourth-largest mortgage lender in the U.S. The amount of loans made next year may fall by as much as 25 percent, he said.

Borrowers with credit scores below 620 as measured by Fair Isaac Corp. have a higher risk of defaulting, and loans to these people are considered subprime. About 20 percent of the U.S. adult population has a score below 620, according to Fair Isaac, the Minneapolis-based company whose FICO ratings are the benchmark for loans and credit cards. The test scores borrowers from 300 to 850 and the lower the mark, the riskier the credit.

Some loans to subprime borrowers, such as those with initial payments that don't even cover the full monthly interest, ``are not good for the investor and not good for the consumer,'' said Richard Kovacevich, chief executive of Wells Fargo & Co., the fifth-biggest U.S. bank by assets.

Delinquency Rates

The last time delinquency rates on lower-rated mortgages jumped was in 2000 as economic growth slumped following the Fed's six rate increases. The central bank has lifted rates 12 times since June 2004, to 4 percent from 1 percent.

The weighted average default rate on the riskier loans rose to 10.1 percent in November 2001 from about 7 percent in early 2000, according to Michael Youngblood, a managing director of asset-backed debt at Friedman, Billings, Ramsey Group Inc., an Arlington, Virginia-based securities firm that specializes in mortgage-related assets.

The late payment rate is 5.51 percent now. Every 1 percentage point increase in that rate means another 34,700 home- loan defaults, according to Youngblood's calculations.

``Employment drives credit conditions in subprime loans and as long as we see a robust labor market we should not expect deterioration in subprime performance,'' said Youngblood, who expects the default rate to reach 5.75 percent by August.

The Labor Department said last week that the unemployment rate in November held at 5 percent for a second month, below the 5.64 percent average over the past 20 years.

`Big Fear'

Irene Von Toussaint, a 33-year-old married mother of one from Bayville, New York, said she's depending on improvements to her credit to avoid paying a rate of as much as 12 percent when the fixed period of her New Century interest-only loan expires in two years. Von Toussaint's credit score is 584.

November 1985 was the last time any prime borrower paid 12 percent on a 30-year fixed-rate mortgage, according to Freddie Mac. Von Toussaint now pays 7.1 percent, compared with about 5.25 percent for a so-called prime customer.

``Paying bills on time is the big fear because I've been disorganized,'' said Von Toussaint, who now has her payments deducted automatically from her checking account.

Loss Estimate

Delinquencies tend to peak two to three years after subprime loans are originated, said Glenn Costello, an analyst at Fitch Ratings in New York. Peak rates of about 20 percent to 25 percent now will likely rise to the high-20s in 2006, he said.

Losses on mortgage bonds backed by subprime loans that will be made next year may rise to 7 percent, contrasting with 2 percent for bonds issued the past two years, should home prices hold steady, said Kenneth Posner, a New York-based finance analyst at Morgan Stanley.

The average yield on bonds rated BBB-, the lowest investment-grade ranking, and backed by payments on adjustable rate mortgages made to the riskiest borrowers is 7.23 percent, the highest since December 2003, according to JPMorgan. The yield was 5.7 percent in October.

The 1.53 percentage point increase compares with a rise of 0.4 percentage point to 5.93 percent for higher quality 30-year mortgage securities guaranteed by Fannie Mae.

Lenders that rushed to provide mortgages amid rising home prices are now stuck with loans worth less than they expected because bond investors are demanding more protection. They are raising mortgage rates to help make up the difference.

`Changing Environment'

``In a rapidly changing environment, you can find yourself ahead or behind the yield curve,'' Robert Cole, chief executive officer of New Century, the No. 2 lender to people with the lowest credit scores, said in a Nov. 15 interview in New York. ``With rates going up, it's more likely behind.''

Profit margins for New Century may narrow to 15 to 25 basis points this quarter from 61 basis points in the third quarter, and 175 basis points in 2004, Chief Financial Officer Patti Dodge said in an interview. A basis point is 0.01 percentage point.

New Century is increasing rates twice as fast for subprime borrowers than for others, Cole said. The company lifted its weighted average rate to about 7.9 percent in November from 7.18 percent in August, pushing up the cost of a $200,000 loan by $98 a month. A prime borrower would only have to pay about $56 more.

Gains from sales of loans at New Century fell 13 percent to $176.2 million in the third quarter from a year earlier even as sales rose 43 percent.

At Kansas City, Missouri-based NovaStar Financial Inc., another lender to borrowers with poor credit histories, profit from sales tumbled 23 percent.

Yield Spreads

``Originators don't charge enough for the risk'' and will lose money as investors demand higher yields, said Alex Wei, who co-manages $3 billion in bonds at Philadelphia-based Delaware Management.

Ameriquest, the largest company specializing in loans to subprime borrowers, had to pay investors a yield of 2.75 percentage points more than benchmark one-month lending rates to sell $14 million of BBB rated mortgage bonds last month.

The extra yield was 1 percentage point higher than on a similar issue sold by the company in June, according to data compiled by Bloomberg. The $1.2 billion AAA rated portion was priced at 24 basis points, 1 basis point higher than in June.

Sales of bonds backed by risky loans will fall next year to about $375 billion, JPMorgan's Flanagan said.

The Fed is signaling that it's unlikely to stop lifting borrowing costs until housing cools. The Commerce Department said last week that new home sales in October increased 13 percent, the most since April 1993, to a record 1.424 million annual rate.

``Froth'' in housing markets may be spilling over into mortgage markets, Fed Chairman Alan Greenspan warned an American Bankers Association convention in September. A rise in interest- only loans that initially don't pay down principle and the introduction of ``exotic'' variable-rate mortgages ``are developments that bear close scrutiny,'' he said.

To contact the reporter on this story: Al Yoon in New York at ayoon@bloomberg.net .