updated 9/9/2007 4:45:46 PM ET 2007-09-09T20:45:46

Could the housing market’s woes spread to bonds held in mutual funds by millions of ordinary investors?

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Some experts — and hedge fund investors who have made big bets that the mortgage crisis will worsen — are saying that’s exactly what will happen. Some bond funds that invest in riskier short-term debt already have been whacked by soaring default rates on bonds backed by subprime loans made to borrowers with weak credit.

Critics charge that Standard & Poor’s, Moody’s Investors Service and Fitch Ratings routinely give triple-A ratings — the safest rating there is — to far too many mortgage-backed bonds backed by subprime home loans.

“The rating agencies just completely missed the boat in their methodology for rating these things,” said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm.

About 80 percent of debt in bonds backed by subprime loans is rated triple-A, the same rating on virtually risk-free U.S. Treasury bonds, experts say.

If that seems shocking, there are bonds backed by delinquent credit card accounts — one of the riskiest forms of debt — in which up to 40 percent of the accounts in the security are rated triple-A, says Drexel University finance professor Joseph Mason.

The Securities and Exchange Commission said Friday it had launched a review of what the three agencies’ ratings mean and whether conflicts of interest were created if they gave advice to sellers of mortgage debt. Credit rating agencies say their role is to rate the creditworthiness of securities, not advise buyers or sellers of bonds.

Congress has also pledged to hold hearings on the role the ratings agencies played in the subprime mortgage mess that has triggered Wall Street selloffs and dampened consumer spending.

The rating agencies defend their methodology and argue that the problems of the $10.4 trillion mortgage-backed market are being exaggerated.

S&P, which is owned by the McGraw-Hill Cos., says it has only had to downgrade about 1 percent of the subprime mortgage debt the agency has rated in recent years, with the overwhelming majority occurring in the lowest-rated debt.

Over the past 30 years, the average five-year default rate for investment-grade mortgage-backed bonds is less than 1 percent, said Chris Atkins, an S&P spokesman.

“Our long-term track record of assessing credit quality of bonds is exceptionally strong,” Atkins said.

At Moody’s, the amount of downgraded bonds is small compared with the total amount issued and has been focused on lower-rated securities, said Claire Robinson, a senior managing director.

The downgraded bonds “are riskier securities that are more prone to downgrade in a stressful environment,” she added.

Still, Richard K. Green, a finance professor at George Washington University, said he is mystified that risky home loans became bundled into triple-A-rated investments.

“The problem is some of these mortgages were just phenomenally bad,” he said. “There was sort of an assumption that house prices would never fall. We now see some markets where they are falling quite a lot.”

Home prices are still falling, and rates that reset to higher levels on many loans could spark more defaults in the coming months.

Andrew Lahde, who runs a hedge fund in Santa Monica, Calif., has been betting on the subprime market’s decline and reaping big gains this year.

He estimates there’s a “very good chance” that most double-A rated subprime mortgage-backed bonds are worthless and believes triple-A debt could also be affected.

“Nobody was looking at the fundamentals,” says Christopher Thornberg, a principal with Beacon Economics in Los Angeles and an adviser to Lahde’s fund. “This was a brave new world,” Thornberg says.

Agencies that rated the bonds the investment banks were selling to investors ignored signs that borrowers were becoming too leveraged, he said, instead choosing to focus on borrowers’ credit scores.

Bond funds typically diversify their investments to protect investors against losses in any one type of bond. The most risk-averse funds invest solely in U.S. Treasury bonds, while others buy corporate debt and mortgage-backed bonds that may have triple-A ratings but carry more risk than that of the federal government.

Huge losses “won’t be the norm” for most mutual funds, predicts Paul Herbert, a senior mutual fund analyst with research firm Morningstar Inc. However, he does expect losses in investment-grade rated bonds backed by the worst-performing mortgages.

Morningstar, in a report published last month, identified several mutual funds that have invested in short-term bonds — including subprime debt — that have suffered losses this year.

Fidelity Advisor Ultra Short Bond A and Fidelity Ultrashort Bond, managed by Fidelity Investments, are both down nearly 5 percent for the year, a sharp drop for a fixed-income fund.

The declines were caused by several factors, including “the fund’s holdings in subprime mortgage securities, which have primarily been in the highest-rated AAA and AA (segments of debt)” and exposure to deteriorating conditions in the bond market generally, Sophie Launay, spokeswoman for Boston-based Fidelity, said in an e-mail.

State Street Corp.’s Advisors’ SSgA Yield Plus has lost 9.5 percent of its value so far this year. State Street declined to comment Friday. The company also declined to deny or confirm a report in the Boston Globe last month, which quoted a letter to State Street clients alerting them to a 42 percent decline this year in the State Street Limited Duration Bond Fund for institutional investors.

Some savvy mutual fund managers have been able to avoid the subprime mess, Morningstar points out, citing the performance of Metropolitan West Asset Management LLC and Legg Mason Inc.’s Western Asset Management.

Investors have the opportunity to pick up distressed debt at bargain prices, Herbert said, but making the right picks could be tricky until there is a clearer sense of the impact of the subprime fallout.

“There may be more for bond-fund investors to worry about,” he wrote in a report last month.

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Data: Latest rates in the US

Home equity rates View rates in your area
Home equity type Today +/- Chart
$30K HELOC FICO 4.36%
$30K home equity loan FICO 5.07%
$75K home equity loan FICO 4.51%
Credit card rates View more rates
Card type Today +/- Last Week
Low Interest Cards 10.86%
10.86%
Cash Back Cards 16.41%
16.40%
Rewards Cards 15.95%
15.94%
Source: Bankrate.com