AMERICANS who have stretched themselves financially to buy a home or refinance a mortgage have been falling behind on their loan payments at an unexpectedly rapid pace.

The surge in mortgage delinquencies in the past few months is squeezing lenders and unsettling investors world-wide in the $10 trillion U.S. mortgage market. The pain is most apparent in subprime mortgages, though there are signs it is spreading to other parts of the mortgage market.

Subprime mortgages are loans made to borrowers who are considered to be higher credit risks because of past payment problems, high debt relative to income or other factors. Lenders typically charge them higher interest rates -- as much as four percentage points more than more-credit-worthy borrowers pay -- one reason subprime mortgages are among the most profitable segments of the industry.

They also have been among the fastest-growing segments. Subprime mortgage originations climbed to $625 billion in 2005 from $120 billion in 2001, according to Inside Mortgage Finance, a trade publication. Like other types of mortgages, subprime home loans are often packaged into securities and sold to investors, helping lenders limit their risks.

Until the past year or so, delinquency rates were low by historical standards, thanks to low interest rates and rising home prices, which made it easy for borrowers to refinance or sell their homes if they ran into trouble. But as the housing market peaked and loan volume leveled off, some lenders responded by relaxing their lending standards. Now, the downside of that strategy is becoming more apparent. (See related article.)

Based on current performance, 2006 is on track to be one of the worst ever for subprime loans, according to UBS AG. "We are a bit surprised by how fast this has unraveled," says Thomas Zimmerman, head of asset-backed securities research at UBS. Roughly 80,000 subprime borrowers who took out mortgages packaged into securities this year are behind on their payments, the bank says.

Though delinquency rates on subprime mortgages originated in the past year have soared to the highest levels in a decade, economists don't expect any significant harm to the nation's economy or financial systems. But if late payments and foreclosures continue to rise at a faster-than-expected pace, the pain could extend beyond homeowners and lenders to the investors who buy mortgage-backed securities.

Several lenders are already feeling the sting. H&R Block Inc., which operates Option One, a major subprime lender, said last week that its mortgage-services unit posted a pretax loss of $39 million in the fiscal second quarter ended Oct. 31, compared with a year-earlier pretax profit of $48.8 million. The Kansas City-based tax-services company said last month it is considering selling Option One, which has been struggling with higher interest rates and defaults, and is closing 12 branch offices.

On Friday, KeyCorp said it reached a deal to sell its subprime Champion Mortgage business. Analysts at Friedman, Billings, Ramsey & Co. put the price for the company's subprime mortgage operation at $130 million, "far below" the $200 million to $250 million they expected. A spokeswoman for KeyCorp declined to comment, except to say that KeyCorp feels it "definitely generated a fair price" for both the unit and its loan portfolio, which was sold separately. She added that KeyCorp was leaving the subprime market because "it no longer fits with our long-term strategic priorities."

Soaring delinquencies are making some lenders more cautious, which is likely to put further pressure on the weak housing market. Yesterday, the National Association of Realtors said that its index for pending home sales for October fell a seasonally adjusted rate of 1.7% from September and was down 13.2% from a year earlier.

Delinquency rates have been rising steadily since the middle of 2005. But the trend has accelerated sharply in the past two to three months, according to an analysis by UBS. The figures don't include loans that lenders were forced to repurchase because the borrower went into default in the first few months; such repurchases also have increased sharply this year.

In October, borrowers were 60 days or more behind in payments on 3.9% of the subprime home loans packaged into mortgage securities this year, UBS says. That's nearly twice the delinquency rate on new subprime loans recorded a year earlier.

Carol Alter, a mail carrier in Aurora, Ohio, says she bought her first home for $99,000 at a sheriff's foreclosure sale in February, but felt pinched right from the start by her nearly $80,000 subprime mortgage. She says closing costs on the loan totaled $6,500, rather than the $2,500 she expected, forcing her to drain her savings and miss payments on her utility bills.

Ms. Alter says she fell behind on her mortgage payments in June after she hurt her leg and missed several weeks of work. She has been able to stave off foreclosure, she says, with the help of a $2,100 interest-free loan from Neighborhood Development Services in Ravenna, which operates a foreclosure rescue fund.

How much higher delinquencies further climb will depend in part on the depth of the current housing slump. Mortgage delinquencies generally rise when the housing market cools because borrowers who are in financial trouble find it harder to sell their homes. In addition, if prices fall, they may not have enough equity in their homes to refinance their mortgage.

The subprime industry's current troubles can be traced back to 2003 and 2004, when defaults were unusually low. Investors who purchased these loans did well and were eager to buy more. That encouraged lenders to lower their standards, making loans to more people with low credit ratings. Lenders also grew less inclined to demand full documentation of income and assets and more willing to offer "piggyback" loans that allowed borrowers to finance 90% or 100% of the purchase price without being required to buy private mortgage insurance.

Many lenders kept introductory "teaser" rates low even after short-term interest rates began rising in June 2005, while increasing the amount the rate could rise on the first adjustment. That meant borrowers would face sharply higher costs when their monthly payments were reset.

Fraud has also increased. Some borrowers who took out no- or low-documentation loans were coached by loan officers or mortgage brokers to inflate their incomes and couldn't afford even their first mortgage payment, says Theresa Ortiz, a foreclosure manager with Neighborhood Housing Services of New York City, a nonprofit that works with homeowners in financial trouble.

Even after the housing market started to cool in late 2005, lenders continued to offer credit on easy terms. Many didn't begin tightening up until a few months ago. Now, they are pulling back. Accredited Home Lenders Holding Co., for example, is doing fewer piggyback and stated-income loans -- or loans that don't require borrowers to fully document their income -- especially for people with lower credit scores. In retrospect, "the tightening process should have started a bit earlier," says James Konrath, Accredited's CEO.

Recent analyses by UBS and by RBS Greenwich Capital show that subprime loans made in 2006 are going into foreclosure at a faster pace than loans made in previous years. In many cases these loans are "so bad right off the bat" and so far beyond the borrower's ability to pay that giving the borrower more time to pay or restructuring the loan wouldn't help, says Michael van Zalingen, director of homeownership services at Neighborhood Housing Services of Chicago, a nonprofit organization that works with financially distressed homeowners.

If delinquencies continue to grow, the pain could also be felt by investors who have flooded into the market for subprime securities. Because of the way mortgage-backed securities are structured, investors who buy investment-grade securities aren't likely to be hurt if losses are close to expectations. But if losses on the underlying mortgages substantially exceed expectations, some investors who buy the riskiest slices of subprime securities are likely to rack up losses. These include hedge funds and investors who buy collateralized debt obligations, pools of debt instruments that are often snapped up by foreign buyers.

Because the underlying loans have gotten riskier, credit-rating agencies are telling issuers of mortgage-backed bonds to set aside more money to cover losses than they did three years ago in order to get an AAA rating for their bonds.

But some recent deals are already coming under review. Standard & Poor's Corp. put one deal backed by loans issued by Fremont General Corp.'s mortgage unit on credit watch for possible downgrade last month and says it could take similar action on deals from several other issuers within the next few months. Fremont declined to comment.

"We are really monitoring very, very closely the portfolios of all the subprime issuers," says Ernestine Warner, head of RMBS Surveillance. "It's an industrywide trend."

Last week, Moody's Investors Service put a third 2006 deal on credit watch for a possible downgrade. Fitch Ratings also has a 2006 deal on credit watch. When mortgage-backed securities are downgraded it is typically during their third or fourth year.

Predicting losses on these securities is a challenge because there's little or no historical evidence to show how subprime loans will perform at a time when home prices are falling, says Thomas Lawler, a housing economist in Vienna, Va. An analysis by Merrill Lynch & Co. found that losses on recent subprime deals could be "in the 6% to 8% range" if home prices are flat next year and could rise to the "double digits" if home prices fall by 5%. Falling home prices could trigger losses not only for investors who bought riskier classes of mortgage-backed securities, but also for some holders of A-rated bonds, according to the report.

Reprinted from The Wall Street Journal of Tuesday, December 5, 2006.