Derivatives linked to sub-prime loans sink

The value of closely watched derivative securities tied to sub-prime mortgages fell to record lows Monday, signaling that pessimism about such loans was worsening.

Separately, Calabasas-based mortgage giant Countrywide Financial Corp. said that housing market conditions “became increasingly challenging” in the second quarter, boosting concerns about the company’s earnings outlook. Its stock slumped nearly 4%.

Rising delinquencies on sub-prime mortgages -- loans made to high-risk borrowers -- have slammed many housing-related stocks since January.

One way Wall Street has been measuring investors’ expectations for sub-prime loans is via credit default swaps. These are contracts that allow investors to buy insurance against the possibility that mortgage-backed bonds they own won’t be paid back in full.

Swaps also can be used by speculators to make the opposite bet -- that bond default rates will rise.

The so-called ABX indexes track the values of swaps on baskets of mortgage-backed bonds. Falling ABX indexes indicate that investors are growing more pessimistic about the value of the underlying bonds.

On Monday, the ABX index linked to 20 mortgage bonds rated BBB-minus (high risk) when they were created in the second half of 2006 tumbled 7.5% to a record low of 45.28, according to London-based Markit Group Ltd., which monitors the indexes. That index has lost more than half its value this year.

More troubling, some analysts said, was that ABX indexes tied to higher-quality mortgage bonds -- rated AAA and AA -- also have fallen in recent days, suggesting growing concern about defaults on those loans.

Hedge funds and investment banks may be driving down the indexes by rushing to offset their exposures to sub-prime-loan debt and so-called collateralized debt obligations, said David Castillo, who trades bonds at Further Lane Securities in San Francisco. The demand for protection against defaults means “because people would rather try to hedge out their risk than take the pain” of simply holding onto their bonds, he said.

Countrywide Financial deepened the gloom in the mortgage market Monday. Although the company said it funded $45 billion in loans last month, up 4% from June 2006, “The housing market continues to soften, and delinquencies and defaults continue to rise,” President David Sambol said in Countrywide’s monthly update.

Countrywide’s shares slid $1.42, or 3.9%, to $34.84.