Buyers in the $565 billion market for so-called sub-prime mortgage bonds are clamoring for the high-yield securities, even though experts increasingly warn that pricing has reached irrational levels.

Rising delinquencies and forecasts of a deepening deterioration in housing have prompted big investors, including hedge funds, to bet against the securities since late 2005. But prices on bonds backed by loans to riskier borrowers have remained stubbornly high, longer than many analysts expected, as yield-hungry investors insist that built-in loss protections are adequate.

The sub-prime home equity market is in the midst of a giant tug of war, said Tom Zimmerman, an analyst at UBS Securities LLC in New York. The market is on the border line.

Market participants, including America's biggest mortgage lender and an analyst at the largest U.S. brokerage firm, are warning that worsening credit quality in housing will soon sting holders of sub-prime mortgage bonds.

There is plenty of data to support their views.

Price appreciation that has enriched homeowners for a decade has come to a halt.

The median price of an existing home fell 1.7 percent in August from a year earlier, the first decline since April 1995, the National Association of Realtors said on Monday. Meanwhile, delinquencies and foreclosures on all types of mortgages rose in the last quarter and will likely increase more, according a report this month from the Mortgage Bankers Association.

At the same time, prices on sub-prime mortgage bonds have crept higher, reducing yields, which typically rise with risks. Countrywide Financial Corp. created a bond this month whose BBB rated class paid 110 basis points above benchmark rates but 35 basis points less than on a similar issue in March. The yield spread on the highest-rated class of the bond also tightened, to 5 basis points from 7 basis points.

At Merrill Lynch & Co., analyst Kenneth Bruce warned that mortgage companies exposed to sub-prime loans may face lower earnings because demand for the debt could dissipate quickly as credit worsens. Rising chances of an asset fire-sale are not priced into the related securities, he said.

Costly loans have steered Countrywide away from its so-called correspondent channel, which feeds the company closed mortgages from other lenders. Chief Executive Officer Angelo Mozilo blamed what he termed irrational pricing on Wall Street firms such as Lehman Brothers Holdings Inc. and Bear Stearns Cos. In a presentation to bond investors last week, he said their deep pockets let them outbid others when creating their own issues.

At the same time, Countrywide hired Lehman and Bear as co-managers to help sell the aforementioned bonds.

A Lehman spokesman declined to comment, and Bear did not respond to calls.

While the investment banks can be aggressive in their pricing for a short time, they will be forced to return to real market pricing quickly because they can't put losses on their balance sheets, as was done by the thrifts for so many years, Mozilo said.

Still, many investors take the view that they will never be touched by losses. A UBS study found that house prices would have to show no appreciation for several years before sub-prime losses exceeded 8 percent, the level at which an average BBB- rated bond would lose its first dollar of principal. However, UBS' Zimmerman said the probability of a BBB- bond breaking rises once volatility is considered.

It is this uncertainty that enlivens the contest between the housing bears and bulls, he said. We are all certain sub-prime losses will rise, but none are exactly sure of how high losses will go.

Equity classes, or residuals, on sub-prime deals are set up to take the first losses. Issues are also over-collateralized, or contain some form of insurance.

Investors around the world are clamoring for mortgage bonds because of the embedded protections and high yields relative to other assets, said Alex Wei, manager of asset-backed securities at Delaware Investments, in Philadelphia. They are especially popular in collateralized debt obligations, securities backed by pools of one or more types of debt

In debt backed by credit card payments, BBB bonds pay about 70 basis points less than sub-prime mortgage issues, and Wei notes that sub-prime bonds, with their credit protections, may turn out to be safer than top-shelf MBS.

There are signs that bearish views are growing amid reports of cooler housing and economic growth. Yield spreads on the ABX.HE index of 20 sub-prime mortgage securities have widened by 30 basis points in recent weeks. Orders for new subprime issues, sold to investors as home equity asset-backed securities, have also been far fewer, analysts said.

Economic reports encouraging the bearish view have resulted in speculation that slowing growth will contain inflation and prompt lower interest rates from the Federal Reserve in 2007. Benchmark 10-year Treasury note yields are anticipating that scenario, with yields falling to their lowest levels in more than six months at 4.55 percent on Monday.

There are market participants who believe that the weaker housing market would have a devastating effect on the economy, Wei said. They have driven yields down by buying Treasuries. Interestingly, they are effectively helping the housing market as lower Treasury rates help reduce mortgage rates, which in turn help housing affordability.

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