U.S. lenders' decision to abandon their most popular subprime mortgages in favor of less risky loans represents their most draconian move yet to stanch losses.

The mortgages, known as 2/28s, produced last year are turning out to be among the worst home loans ever made as record numbers are going delinquent within months. The loans made up 65 percent of subprime volume in 2006, making them a key ingredient for profit during the housing boom.

The shift by lenders, including Washington Mutual Inc. and Countrywide Financial Corp., is changing the face of the subprime business, which has grown to about 14 percent of the more than $10 trillion U.S. mortgage market from less than 3 percent in 1998.

Losing the product will likely exacerbate the shrinkage of the market, whose volumes have already contracted by a third this year, industry watchers said.

They are really going to the other side with the pendulum, said Bob Moulton, president of Americana Mortgage, a Manhasset, New York-based broker.

The 2/28 loan carries a fixed rate for two years before adjusting higher biannually in the following 28. The interest rate on loans can rise 6 percentage points or more at reset.

The loans -- dubbed subprime bread and butter by analysts at the investment bank Credit Suisse -- have been popular with lenders that typically encourage borrowers to refinance before rates change, perhaps to a prime loan as their credit improves.

With the shift by Washington Mutual (WaMu) to 5/25 loans, borrowers have a longer time to repair credit, helping buoy overall loan quality, said David Schneider, president of the Seattle-based lender's loan unit.

INVESTOR-DRIVEN

Lenders have been encouraged to reduce or cut the offering of 2/28s by stricter lending guidance from regulators.

The new guidance urges lenders to show that customers can make higher monthly payments once the loan resets to a higher rate. Previously, borrowers only had to demonstrate that they could meet payments set according to lower initial rates.

At Countrywide, nearly 60 percent of borrowers with subprime adjustable rate mortgages would not have qualified in the last quarter of 2006 if the federal guidelines had been followed.

Lenders abandoned their 2/28 programs one after another in a matter of days after rating agencies announced hundreds of bond issue downgrades tied to these subprime loans and tightened credit requirements last week.

Other lenders making the move included H&R Block Inc.'s Option One Mortgage, Merrill Lynch & Co.'s First Franklin and Accredited Home Lenders Inc.

The alteration of loan products was put into high gear in terms of timing and magnitude of change as the rating agencies tightened their criteria, said Sharon Greenberg, a bond analyst at Credit Suisse in New York.

Securitizations in the subprime mortgage bond market soon came to a grinding halt, and lenders looking to address new rating criteria raised rates on riskier loans as much as 1.5 percentage points, according to a Credit Suisse report.

The decision (to stop 2/28 lending) reflects substantial tightening of secondary market demand, Countrywide said in a statement. Countrywide is still making 3/27 subprime loans.

LOAN VOLUME DWINDLES

The move by WaMu and others is the latest and perhaps biggest change they have taken in the past year to tighten standards.

WaMu, which makes subprime loans through its Long Beach Mortgage unit, is still struggling with the industry, though it cut quarterly losses by two-thirds to $37 million in the second quarter from the first part of 2007.

Subprime production volumes may continue to dwindle given the tightening of standards, WaMu's Schneider said. But the loss of 2/28s themselves may not make a big difference since longer-term mortgages such as 5/25s can be obtained at rates only about 0.125 percentage point higher, he said.

Tighter standards are partly to blame for the extended housing slump as marginal borrowers who once qualified for a loan can no longer do so, analysts said. Preserving subprime lending while preventing irresponsible loans is thus a balance that must be struck for the sake of the economy, Federal Reserve Chairman Ben Bernanke said on Wednesday.

We are striking that balance here, Schneider said. We are still actively providing credit in the subprime space.

New York Mortgage