Moody’s Investors Service downgraded the underlying ratings on $6.56 billion of California Housing Finance Agency home mortgage revenue bonds to A3 from Aa3 Monday, citing a “severe deterioration” of the state’s housing market.

The bonds remain on watch for possible further downgrade.

“The downgrade reflects a combination of factors, including the severe deterioration of California housing markets, significant increases in delinquencies and foreclosures of home mortgage revenue bond loans,” and weakened mortgage insurance, Moody’s analyst William Fitzpatrick said in a report.

About $2.7 billion of the debt is structured as variable-rate demand obligations with Aaa backing from the U.S. Treasury Department via liquidity from Freddie Mac and Fannie Mae under the temporary credit and liquidity program. Freddie and Fannie were seized by federal regulators in September 2008.

CalHFA’s mortgage portfolio has seen delinquencies and foreclosures surge as the state economy and housing market have weakened.

The proportion of delinquent loans in the portfolio rose to 17.9% at the end of January from 14.1% at the end of June 2009. About 11.5% of loans were 90 or more days delinquent or in foreclosure at the end of January, up from 7.9% seven months earlier. Moody’s said CalHFA’s interest-only loans — which account for almost a quarter of its portfolio — appear “particularly vulnerable to further delinquencies going forward.”

“Moody’s views the sustained decline in performance of the agency’s mortgage portfolio as a key risk that continues to contribute to the weakening of [home mortgage revenue bonds’] credit quality,” Fitzpatrick wrote. “The rising delinquencies combine with a severe decline in California house prices, which increase losses upon foreclosure and delay the ability to dispose successfully of foreclosed homes.”

The weakness is also exacerbated by weakening in the mortgage insurance programs that were intended to protect the agency against losses on the home mortgages. Private mortgage insurance companies have taken a beating during the housing crisis, and CalHFA itself weakened the protection it offered on the portfolio through its in-house mortgage insurer. The weakening mortgage insurance affects about 41% of the loans, according to Moody’s.

Analysts said several strengths partially offset its concerns about the mortgage portfolio, including over-collateralization of the mortgage pool. The program’s asset-to-debt ratio was about 1.067 at the end of fiscal 2009. Fitzpatrick said preliminary analysis of unaudited results shows that the ratio held near that level through the end of the year.

Moody’s said cash-flow projections for the home mortgage revenue bond program demonstrate its “ability to continue to meet debt-service obligations under a variety of stressful scenarios.”

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