SAN FRANCISCO - Frozen out of the capital markets in recent weeks, state and local housing finance agencies are being forced to curtail lending to low- and moderate-income homebuyers at the worst possible time for the broader economy.

Housing finance agencies in California and across the nation long seemed to have dodged the worst of the housing market's woes. While they lend to many first-time homebuyers with small down payments, HFAs avoided the sort of undocumented, negative-amortizing, infinitesimal credit score lending that brought down the nation's big subprime lenders. That doesn't mean they're immune to the fallout.

"This is a group of generally very sophisticated issuers that are very well managed, have a lot of tools at their disposal and are very strong financially," said Wendy Dolber, a managing director at Standard & Poor's in New York. "But the agencies are learning the same lessons that the rest of us are learning right now: When things go wrong, it can have a domino effect, and we're all seeing the interrelationships of the market."

The California Housing Finance Agency is one of many that's juggling financial market woes - surging rates on failed variable-rate debt, failed remarketings, downgrades among swap counterparties, mortgage insurers, and guaranteed investment contract providers, and a frozen new-issue market - amid a weak economic fundamentals, including falling home prices and rising foreclosure rates.

Moody's Investor's Service put the agency's Aa3 issuer credit rating on watch for possible downgrade last week. That affects about $1.5 billion of debt, primarily multifamily housing revenue bonds, including almost $1 billion of uninsured variable-rate demand obligations.

Moody's reaffirmed the Aa2 rating on the agency's $7 billion single-family home mortgage revenue bond program. Standard & Poor's rates both pools AA-minus with a stable outlook.

"This action is based upon the combined effects of increased losses from delinquencies and foreclosures from single family mortgages, heightened risk related to the agency's variable-rate debt, resulting from a volatile market and counterparty risk, and a lending initiative that placed additional leverage on the agency's balance sheet," Moody's analysts William Fitzpatrick and Florence Zeman wrote in a report.

That's sent the housing agency's staff scrambling to fortify its balance sheet, as management works to show Moody's and investors that it's strong enough to manage the credit crunch. Senior management updated the HFA board of directors on the credit crisis late last week.

"At this point, there's still no access to the capital markets," said finance director Bruce Gilbertson. His first priority right now is managing the agency's large variable-rate debt portfolio.

The agency has about $8.5 billion of debt outstanding, including about $5.5 billion of hedged variable-rate debt. About $770 million of the debt is hedged with swaps with AIG Financial Products and Lehman Brothers Special Financing. The agency plans to replace those swaps as soon as it can because it does not want the counterparty risks associated with the two firms.

Interest rates on the agency's weekly variable-rate debt jumped to above 10% late last month after the Lehman Brothers bankruptcy touched off a panic in the money markets, up from 2.3% before the crisis. Rates fell back to the 5% to 9% range on debt that successfully remarketed last week, but about $900 million has been put back to liquidity providers, ironically saving the agency money by paying rates of 5% to 6%.

The surge in rates has cost the agency about $4.6 million in the six weeks since Aug. 1. Gilbertson hopes the market will return to normal at some point and allow that debt to start remarketing, but he's also got to plan for the possibility that it won't. If that happens, the terms of the agency's standby bond purchase agreements require that the debt be repaid over five years.

A related but separate problem is the credit rating.

If Moody's downgrades the agency - in large part because it can't remarket its debt right now - about $1 billion of its multifamily debt will no longer be money market eligible, forcing even more bonds back to liquidity providers and into accelerated repayment.

"We are worried a little bit about this becoming a self-fulfilling prophesy," he said.

Gilbertson says his agency has submitted data on its mortgages and delinquencies and is waiting for Moody's to run its stress tests on the data. In the meantime, the agency has run its own tests and believes it's well enough capitalized that it should be able to keep its rating.

About 7.2% of the agency's borrowers - consumers who have California HFA mortgages - were delinquent on their mortgages on July 31. The bulk is covered by Federal Housing Administration guarantees or the agency's own mortgage insurance pool, which has more than three times the industry standard capital ratio and is 75% reinsured by Genworth Financial. The riskiest part of its lending portfolio is the $1.3 billion of loans it's made without mortgage insurance to borrowers who had significant down payments. That pool has a delinquency rate of just 2.6%.

"We have more assets on the balance sheet than liabilities," Gilbertson said. "The big risk is liquidity" if the variable-rate market continues to fail or its access is blocked.

As if his plate wasn't full enough, the agency also has about $1 billion in standby bond purchase agreements that expire in the next year and a few SBPAs with European banks that have been downgraded, including Depfa. Gilbertson and his staff will have to find banks to takeover those deals.

The magnitude of the credit crisis and the many risks facing issuers has forced Gilbertson and the agency's management to consider previously unthinkable options for freeing up capital or refinancing.

Some of the options the California agency is exploring include refinancing at fixed rates, seeking letters of credit in a market where few are available, asking Fannie Mae to back some of its debt with a letter of credit, selling off mortgages, and seeking a $1 billion line of credit from a California investment pool that already provides the agency with a $350 million line of credit that finances mortgages while the agency waits for bond proceeds.

In the meantime, the agency has tightened its belt. Among other things, it suspended most forms of down payment assistance, stopped offering mortgage with terms greater than 30 years, raised down payment and credit requirements, and stopped offering forward loan commitments to builders and developers.

"When you look at these particular issuers and ask if they could have done things differently, the one thing that you can say is that their lending practices and financial practices have been very strong," Dolber said. "They're not sitting on a pool of subprime mortgages ... They're fully documented, closely underwritten loans that the agencies hold in their portfolios until loan maturity."

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