Bank of America Corp., potentially among the most affected, dropped more than 5%. Bank bonds also fell, and the cost of buying protection against a possible debt default by banks climbed.
"The level of uncertainty in the economy is at extraordinarily high levels to begin with," said Jack Scott, chief investment officer at BlackHawk Capital Management, a Charlotte, N.C., money manager that owns mortgage securities. "The foreclosure problem adds another layer of acute uncertainty."
So far, the foreclosure crisis hasn't affected consumer mortgage rates, which remain near record lows. They are closely linked to rates on U.S. Treasurys, which have tumbled in recent months.
The crisis has been escalating for several weeks, as banks suspend foreclosures across the country, citing flaws they have uncovered, including faulty or missing documentation. Tales of mismanagement within the foreclosure process—including so-called robo-signers, who were paid to rubber stamp documents without properly reviewing them—are emerging daily.
Until recently, investors hadn't fled financial stocks. If the issues raised about foreclosure practices in recent days are easily resolved technical glitches, with most foreclosures resuming after brief delays, then the impact on most investors would be small.
"The [mortgage] market seems to be functioning relatively well, but that could change depending on how we see this play out," said BlackRock Inc. portfolio manager John Vibert.
But some fear that it may be difficult to do any foreclosures for a while. The risk is that foreclosure flaws are so widespread, or the political furor so heated, that the entire process grinds to a halt, as Citigroup analyst Joshua Levin said in a conference call this week.
In some cases, that would choke off much of the cash flow used to pay mortgage bondholders.
Another concern is that banks could be forced to modify billions of dollars in loans, including reducing principal, which could leave bondholders as big losers.
"All this does is increase uncertainty and make me question my estimates of returns" on mortgage bonds, said Mr. Scott of BlackHawk, which bought mortgages that aren't guaranteed by government agencies near the bottom in early 2009. BlackHawk started trimming its mortgage holdings this summer after a run-up.
Banks, meanwhile, could be hit with investor lawsuits, and foreclosure delays could bring short-term losses. Some investors are pushing for banks to take back nonperforming mortgages in cases of faulty documentation.
Such worries helped push down shares of Bank of America on Thursday, in their biggest one-day drop since mid-July. Wells Fargo, with its own large mortgage portfolio, fell more than 4%, as did Citigroup Inc. J.P. Morgan Chase & Co. dropped 2.8%.
The annual cost of buying five-year credit-default swap protection on $10 million of Bank of America debt rose from $155,000 on Monday to $193,000 on Thursday, with the bulk of the rise coming in the past two days, according to data provider Markit. The cost of protecting similar debt from Wells Fargo rose to $129,000 from $95,000 on Monday.
"If nothing else, this is creating uncertainty for the banks," Nomura Securities bank analyst David Havens wrote in an email. "Our take is that it could be quite negative for the banks, and the markets are waking up to this very quickly."
The latest foreclosure headache is just one in a string for owners of mortgage securities not backed by government agencies. This $1.3 trillion market has yet to fully recover from its implosion starting in 2007.
Estimates of the size of the foreclosure problem are still forming. Some $154 billion in mortgages could be affected by foreclosure delays, according to an estimate this week by Laurie Goodman, senior managing director at mortgage-bond trader Amherst Securities Group LP in New York.
Morgan Stanley trading-desk analyst Greg Gore estimated in a conference call on Tuesday that as much as $134 billion of mortgage bonds held by the nation's four biggest banks could ultimately be affected by foreclosure delays.
For now, many bond investors doubt the damage will be extensive. But wild cards remain. For starters, attorneys general in all 50 states are investigating foreclosures.
Some investors still feel burned by a 2008 settlement between attorneys general and Bank of America, after the bank bought Countrywide Financial.
The bank agreed to modify mortgages, and investors say they are bearing the costs unfairly. They fear foreclosure investigations could result in mortgage modifications that once again hurt investors.
In an Oct. 7 ruling, a New York state justice dismissed a lawsuit by investors who argued they shouldn't bear any of the cost of the $8.4 billion settlement.
Mortgage-bond investors will get more information at the end of the month, when they get fresh data on cash flows from the bonds they own. But that data may only partially reflect the impact of recent foreclosure delays.