3rd UPDATE: Subprime-Mortgage Indexes Jump After BofA Deal

NEW YORK (Dow Jones)--Subprime mortgage-bond indexes posted their biggest one-day surge since at least May 2010 on Wednesday after Bank of America Corp.'s (BAC) milestone settlement over faulty home loans removed a degree of contention in the $1.2 trillion market, which had been suffering for months.

The $8.5 billion settlement comes as investors have been intensifying scrutiny of the private mortgage market following its dizzying rise since 2008. Prices have dropped since February as subprime bond revenue has deteriorated faster and the economic backdrop darkened, denting sentiment of investors already jaded from shouldering losses they claim are the responsibility of banks that created the securities.

Bank of America agreed to settle claims that loans in 530 deals owned by powerful investors such as BlackRock Inc. (BLK), MetLife Inc. (MET) and Allianz SE's (ALIZF, ALV.XE) Pacific Investment Management Co. violated terms of bond contracts, or were improperly treated when in default. While the settlement is limited in scope, analysts said the progress in achieving it indicated that hurdles that have kept investors from seeking compensation, such as finding support from trustees, could be overcome.

"It erases a bit of the uncertainty that is a black cloud hanging over this industry," said Sue Allon, chief executive at Denver-based Allonhill, a mortgage-risk company hired to work on one of the only two private residential mortgage securities constructed since the financial crisis.

The ABX 06-2 AAA index of subprime mortgage bonds surged nearly three points, to a bid of 49-8/32 and offer of 50-24/32, according to dealers' quotes before the market close. It had declined more than 25% since February.

Dealers and investors holding bonds issued by Countrywide Financial, the top mortgage lender acquired by Bank of America in 2008, scrambled to evaluate the impact on their bonds. Those covered by the settlement could see gains, on average, of 8%, said one investor who participated in the settlement.

Doubts about subprime bonds had also been magnified as U.S. economic reports weakened, the Greek debt crisis festered and the Federal Reserve Bank of New York sold more than $10 billion in mortgage bonds from its Maiden Lane II portfolio since March. The Fed has slowed sales of the bonds absorbed from American International Group Inc. (AIG) as prices dropped, and dealers urged it to curb the supply until demand improved.

The New York Fed's Maiden Lane entities are among the 22 investors represented in the Bank of America settlement

The settlement is a reminder of "optionality" still in the market that could benefit other investors, said Jesse Litvak, a managing director at Jefferies & Co. in Stamford, Conn. Investors on Wednesday felt comfortable taking risk as Greece's Parliament passed an austerity plan aimed at securing an international bailout and preventing a sovereign-debt default, he said.

"When you factor in that our prices are off seven to 10 points from the highs in February, maybe this is the catalyst--in conjunction with Greece passing the austerity vote--which gets the market out of the doldrums," Litvak said.

Data this week showing home prices slowed their decline in April and a rise in pending home sales for May soothed investors in subprime bonds, whose value is often a derivative of the money that can be recouped in a property sale. These calculations, versus income from any settlement, would continue to drive the market, said the investor in the settlement.

"The market had been leaning against any positive outcome here, as well as housing in general and the foreclosure morass, so anything less dire in any of these areas is likely to have an outsize impact on mortgage credit," said Chris Sullivan, chief investment officer at the United Nations Federal Credit Union in New York, which manages $3.2 billion.

Bank of America stock rallied as investors believed the settlement will help relieve a drag on earnings. Bond insurers including MBIA Inc. (MBI) rose as investors expected the companies would see proceeds from the settlement.

-By Al Yoon, Dow Jones Newswires; 212-416-3216; albert.yoon@dowjones.com

--David Benoit, Lauren Pollock and Corrie Driebusch contributed to this article.

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