Loan Standards Up As Defaults, Wall St. Hit Banks, Lenders

Mortgage lenders are restricting credit to a wide range of borrowers amid rising home loan defaults, analysts say, a move likely to prolong the housing slump and sap economic growth.

The credit squeeze has turned into a credit freeze in recent days, as Wall Street has shunned mortgage-backed securities.

That's accelerated lenders' push to raise rates on some mortgage products, scrap some types of loans altogether and more closely scrutinize borrowers.

"The mortgage spigot is closing. Even prime borrowers are having difficulty now," said Mark Zandi, chief economist at Moody's Economy.com.

Tight credit could put more pressure on home prices and sales, which could spur further defaults.

Mortgage lenders got some relief Monday on reports that government-sponsored enterprise Fannie Mae fnm wants to buy more loans from struggling lenders. Fannie shares rose 10% while its sibling, Freddie Mac fre, climbed 8%.

Countrywide and other mortgage lenders surged on the report and other positive news.

"We need them (Freddie and Fannie) to provide that liquidity. ... It would be huge," said Matthew Howlett, an analyst at Fox-Pitt Kelton.

NovaStar Financial nfi, which plunged early Monday after suspending mortgage fundings, said it will resume operations. Down 35% early, it closed up 6%.

Bear Stearns bsc, which has been slammed for its exposure to subprime and other debt, jumped 5% as investment banks bounced back.

But real problems remain. Defaults have soared among both subprime borrowers with poor credit histories and so-called Alt-A, or "liar loan," borrowers who didn't have to verify income. Even loans to people with good credit increasingly are going bust.

Insatiable demand for mortgage-backed securities fueled the housing boom over the past five years by encouraging lenders to write increasingly risky loans. Lenders could unload that risk and free up capital by bundling loans into securities that had high credit ratings and offered good returns.

But a spike in foreclosures has sharply curbed investor interest in the securities.

"There's definitely a backlash now in which investors are saying they don't want to hold anything with a mortgage attached," said Guy Cecala, publisher of Inside Mortgage Finance.

"Loans are going to be much harder to get and more expensive to get," Cecala said.

That will make it harder for borrowers with adjustable-rate mortgages to refinance when their interest rates adjust higher. An estimated $1 trillion of ARM loans is due to reset this year -- raising the specter of higher monthly payments, especially on loans with teaser rates to start.

Many of the loans were made near the top of the market, so borrowers have little home equity to fall back on. Many may be underwater.

"There's no question that we're still on the rise for delinquencies and defaults across the board," Cecala said.

Rising foreclosures and plunging demand for mortgage-backed securities have put dozens of lenders out of business in the last year.

On Monday, American Home Mortgage ahm, which offered Alt-A mortgages, filed for bankruptcy protection. It had earlier halted operations and fired almost all of its 7,400 employees.

Some lenders have stopped offering certain loans.

Wells Fargo wfc has stopped lending to prime borrowers who don't show proof of income. It also curtailed funding of Alt-A loans via outside brokers, while Wachovia wb has stopped such fundings entirely.

Subprime loans used to be a small share of the total mortgage market, but they soared to 20.1% of the total in 2006, according to Inside Mortgage Finance. Their share fell back to 14% in the first quarter and likely dried up further in the second quarter.

The housing slump has dragged down economic growth over the past year. Analysts say current credit conditions could make matters worse unless Fannie or Freddie step in or the Federal Reserve lowers interest rates.

"It'll weigh heavily on the economy and argues for some Federal Reserve easing," Zandi said.

The Fed almost certainly will keep short-term rates at 5.25% at its meeting Tuesday. But some analysts expect the Fed to express greater concern about the economy as a first step toward an eventual rate cut.

"The odds are rising that it will ease," Zandi said.