Repossessions of US homes are set to hit their highest level in decades after the housing slow-down put millions of “sub-prime” borrowers at risk of default. And the impact will be felt by investors worldwide.

One in five mortgages taken out by high-risk creditors in the US in 2005 and 2006 will end in repossession, “exceeding the worst foreclosure experience in the modern mortgage market, which occurred during the ‘oil patch’ disaster of the 1980s”, according to the Centre for Responsible Lending.

Banks targeted the higher-risk sub-prime mortgage market aggressively as rising house prices reduced the risk of lending to people with poor credit ratings because they could easily remortgage their properties to keep up with their payments. But since the US market has slowed, more subprime borrowers have found it difficult to repay their loans, which typically carry a rate two to three percentage points more than prime mortgages.

That price boom masked fundamental problems in the mortgage market as a result of the banks’ aggressive lending, the Centre said in a recent report.

“Even during the recent period of strong housing appreciation, sub-prime foreclosures have been extraordinarily high with as many as one in eight sub-prime home loans ending in foreclosure within five years,” the report said. “For many borrowers, strong house price growth increased the amount of equity in their homes and enabled them to refinance their mortgages despite being behind on payments.”

A slew of mortgage lenders such as HSBC, NovaStar Financial and New Century Financial have given warning of problems in their sub-prime home loan books and shares of many loanmakers have dived.

The expected jump in foreclosures could not only deprive more than two million subprime people of their homes, but also reverberate through the financial services industry.

Brad Hintz, a banking analyst at Sanford C Bernstein, said: “So far, the fallout looks to be confined to the homeowners, the reputation to some of the brokers who have packaged the sub-prime mortgages into potentially loss-making bonds and the losses to those investors. But the big fear is that investor concern about credit risk spreads from mortgage-backed bonds to the entire fixed-income world. This would, in turn, raise the cost of borrowing across the board as lenders seek to stem a flight to safer government bonds.”

An increase in the cost of borrowing would constrain the economy because it would make it more difficult for companies to finance acquisitions and to borrow money for investment, Mr Hintz added.

In some cases, it would also add to the cost of servicing existing debt, which could be serious for private equity firms which often fund deals with loans and high-yield bonds.

Analysts said that it was too early to say how far America’s sub-prime woes would spread.

Residential mortgages, most of them sub-prime, were used to back about $200 billion (£100 billion) of specialised bonds, known as collaterised debt obligations, in 2005 alone. These were bought by pension funds, hedge funds, banks and insurance companies and the declining subprime loan books will drag down their profits, as well as hitting their investors and pensioners.

Banks such as HSBC, Merrill Lynch and JPMorgan have been buying up sub-prime loans in the last two years some of which they are now trying to sell back to their originators.

US banks have faced increasing criticism in recent weeks for allegedly reducing their financial requirements as they push to offer more high-margin subprime mortgages.

Subprime loans make up 12.75 per cent of the $10,200 billion US mortgage market, against 8.5 per cent in 2001, according to Inside Mortgage Finance. The proportion of new mortgages issued that were subprime has jumped from about 1 per cent in 1994 to about a quarter in 2006.

Ben Bernanke, Chairman of the Federal Reserve, is concerned. “We have been following it carefully. It’s obviously very bad for those who borrowed in those circumstances, and it’s not good for the lenders, either, who are taking losses,” he said last week in his semiannual economic report to Congress.

The extent of the fallout may be anybody’s guess, but at the very least the flow of bad news from subprime specialists is likely to continue for some time to come.

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