Despite dramatic rise delinquencies and foreclosures, subprime mortgage lending continues to function and new loans are being made, Federal Reserve analysts said in their biannual monetary policy report to Congress.

Credit has tightened as investors in subprime mortgage-backed securities (MBS) have scrutinized the underlying loans more carefully, forcing lenders to tighten underwriting standards, the report said. Not only have underwriting standards gotten tougher, but subprime borrowers are paying more for loans, the report noted.

Credit spreads on the lower-rated tranches of new subprime securitizations have “increased sharply” this year, and issuance of subprime MBS “has moderated from its vigorous pace of the past couple of years.”

Click here to see a graph of the gross issuance of Alt-A and subprime mortgage-backed securities between 2002 and 2007.

The annual rate of gross issuance of MBS backed by subprime and Alt-A mortgage loans peaked in the first half of 2006 at about $70 billion per year. While the rate of subprime MBS issuance has fallen below 2004 levels, Alt-A issuance has remained steady.

Combined subprime and Alt-A MBS issuance, however, continued at an annual rate of $60 billion a year in the second quarter of 2007 — still well above 2004 levels.

Credit spreads on securities backed by subprime mortgages have more than quadrupled from last year, from around 200 basis points over LIBOR to more than 800. LIBOR, the London Interbank Offered Rate, is a short-term rate banks use as a benchmark when lending each other money. The higher spread means lenders pay more to borrow money, and pass those costs along to their customers.

Credit tightening may be a bigger factor than higher interest rates in declining home sales, the report said. Sales of existing homes were down 4.5 percent for the three months ending in May 2007, compared to the second half of last year, the report said.

“The further weakening of housing demand this year likely reflects, in part, tighter lending standards for mortgages, and it occurred despite mortgage rates that were relatively low by longer-run standards,” the report said.

Declining sales have made it more difficult for home builders to reduce their inventories of new homes for sale, the report said. The months’ supply of unsold new homes in May was more than 60 percent above the high end of the narrow range it occupied from 1997 to 2005, the report said.

Published estimates “probably understate the true inventory overhang in this sector to the extent that they do not account for the surge in canceled sales in the past year,” the report said. Cancellations return homes to unsold inventory but are not incorporated in official statistics.

Home prices “appear to have moved roughly sideways” in the first half of 2007, the report said, citing the repeat transactions price index published by the Office of Federal Housing Enterprise Oversight, which rose at an annual rate of 2 percent in the first quarter of 2007. For April and May combined, the average price of existing single-family homes — which does not take into account changes in the mix of houses sold — was down 1 percent from a year ago.

The slowdown or reversal in price appreciation has created problems for subprime borrowers with adjustable-rate mortgages (ARMs) facing payment resets.

When house prices were rising rapidly and rates on new loans were lower, many of these borrowers qualified to refinance into another loan with more-favorable terms, the report said. Now that housing prices have decelerated and rates have moved higher, opportunities for refinancing have been reduced.

“Moreover, investor-owners may have been tempted to walk away from properties with little or no equity,” the report said. “Subprime mortgages originated in late 2005 and 2006 have shown unusually high rates of early delinquency, suggesting that some lenders unduly loosened standards during that period.”

Delinquency rates on subprime ARMs, which account for about 9 percent of all first-lien mortgages outstanding, continued to climb in the first five months of 2007 and reached a level more than double the recent low recorded in mid-2005.

The rise in delinquencies has begun to show through to new foreclosures. In the first quarter of 2007, an estimated 325,000 foreclosure proceedings were initiated, up from an average quarterly rate of 230,000 over the preceding two years. About half of the foreclosures this year were on subprime mortgages, the report said.

“However, despite the ongoing problems, the subprime market has continued to function, and new loans are being made,” the Fed report said.

In delivering the report to members of two Congressional committees this week, Federal Reserve Chairman Ben Bernanke said the rapid expansion of the subprime market was “clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud.”

He said that according to some estimates, losses associated with subprime mortgages could total between $50 billion and $100 billion.

Bernanke said the Fed will propose new rules to combat unfair or deceptive mortgage lending practices later this year, which could include restrictions on prepayment penalties and stated-income and low-documentation lending, along with more thorough evaluations of a borrower’s ability to repay.

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