CHICAGO – Subprime borrowers are having growing problems making their mortgage payments, and there has been evidence of outright fraud in some low-documentation loans.

But the effect of such problems on the specialized companies that provide insurance for bonds created by pooling large numbers of these now-troubled loans remains murky.

The issue was raised last week when Standard & Poor’s and Moody’s Investors Service, the two largest bond-rating agencies, reported that billions of dollars worth of subprime mortgage-backed bonds issued last year were performing worse than they expected and will likely continue to deteriorate as the housing market continues to decline at least into early 2008.

Bond insurers MBIA Corp. and Ambac Financial Group Inc. have potential subprime mortgage securitization exposure of $5.5 billion and $9.9 billion, respectively, but much of that exposure is to mortgages written well before the troublesome year of 2006, which has been the biggest problem in terms of defaults.

Even so, the companies have seen their share prices take a hit this year as investors consider whether the insurers teeter on the verge of insolvency or are poised to benefit from possible increased demand for bond insurance in light of all the problems.

An MBIA spokesman declined to comment specifically on how the rating agencies’ changes would affect the company, but he noted that the company recently provided an update on its collateralized debt obligation strategy and subprime exposure. An Ambac spokesman said the company has listed its exposure on its Web site and the recent downgrades had no impact on its mortgage-backed securities exposures.

MBIA shares fell $1.05 to $58.80 Wednesday, closer to the bottom of their 52-week trading range of $56 set last August than to their high of $76.02 set in January.

Ambac shares fell $1.66 to $83.39, down from the 52-week high of $96.10 in May. The shares’ 52-week low of $80.89 came last July.

Neither Standard & Poor’s nor Moody’s addressed the effect the poorly performing mortgages were likely to have on bond insurers, though a Standard & Poor’s analyst said the firm was in the process of updating its June report on how the bonds’ performance will affect insurers.

“Preliminary indications are the impact is minimal,” said David Veno, director of global bond insurance ratings at Standard & Poor’s.

Also yet to be determined is how the bonds will affect the payment performance of collateralized debt obligations, or CDOs, which are packages of securities that allow investors to choose different levels of risk for correspondingly higher interest payments. These also sometimes carry coverage by insurers.

Fitch Ratings Inc. analyst Thomas Abruzzo said financial guarantors typically employ so-called credit enhancements that go above the minimum needed for a high credit rating, giving them more “cushion” to absorb worse-than-expected payment performance by underlying mortgages.

That means that even if more and more borrowers default on their loans, the insurer is unlikely to be affected, while investors lower on the credit scale take the hit.

But Pershing Square Capital of New York has argued for months that both MBIA and Ambac are undercapitalized for an “upcoming payment shock” that the hedge fund warned was coming in a report it released in May. Pershing said then that the rating agencies “have it wrong,” and that payment patterns will continue to deteriorate.

In a brief interview last week, Pershing Square’s Bill Ackman had a quick “I told them so” reaction to the rating agency revisions.

He argues that rating agencies, paid a fee by the companies they rate, have an incentive to take it easy when talking about the impact on insurers, and the picture is likely to get worse as more borrowers default.

But others argue that they have heard this all before, most recently after Hurricane Katrina hit in 2005, and predictions of widespread bond defaults failed to materialize.

Ironically, a large part of the current problem originates in the white-hot housing market of the past few years, particularly in areas such as California, where rapidly appreciating home prices gave mortgage lenders a measure of safety: If a borrower needed to get out from under a mortgage, it could usually be done, and net a nice profit that would cover the mortgage principal.

But those days are over, economists warn. David Wyss, Standard & Poor’s chief economist, said that housing prices should continue to drop in parts of the country well into next year, and some of the biggest bubble spots could see price drops of up to 20 percent, putting subprime borrowers in a tough spot if they can’t make their mortgage payments, because they will be unlikely to be able to sell their home at a high enough price to pay off the mortgage.

CreditSights Inc. analyst Rob Haines argued in a recent note that while MBIA is likely to see an “uptick in losses on CDOs backed by (residential mortgage-backed securities) collateral and subprime mortgage securitizations, we believe that the fallout will be negligible from a financial strength perspective.”

A service of the Associated Press(AP)