NEW YORK (Reuters) - The allure of rotting mortgage bonds has grown so strong that Wall Street’s vultures have begun picking over their carcasses -- a signal the credit crisis has entered a crucial stage in its vicious cycle.

In the past two months, these intrepid investors have begun betting billions of dollars on a hunch that mortgage security prices have fallen enough. It is a risk few have taken for a year or more as the credit crisis rooted in this very market wreaked havoc in financial markets around the world.

In early February, bid lists for bonds backed by middle-quality mortgages found no takers, even at what were then considered fire-sale prices, between 75 cents and 80 cents on the dollar. But the following month, though, Jeffrey Gundlach, chief investment officer at bond manager Trust Company of the West, began snapping up these same securities at 65 cents on the dollar during what he calls the “darkest moments for the markets.

“You had a massive, massive supply-demand imbalance that had developed into a death spiral,” Gundlach said of the systemic liquidity squeeze in early March. “Those securities were really cheap against the fundamentals, so we went in big and started buying.”

WATCH THE VULTURES

The behavior of Gundlach and those like him is important because this brand of investor -- patient, value scavengers willing to stomach some initial loss in exchange for huge windfalls when a market turns -- frequently signals that a market is forming a bottom when they are active.

In early March, banks and hedge funds stripped of access to credit had to sell mortgage securities to raise cash for margin calls. That helped send already panicky U.S. markets into a full-fledged credit freeze.

But the Federal Reserve stepped in and announced that it would lend up to $200 billion of U.S. Treasury securities to banks for 28-day periods in return for debt, including a range of mortgage-backed securities. That broke a month-long sell-off, sending the mortgage securities rallying strongly.

That set in motion a number of major buyers into the mortgage market.

In recent months, a number of big players have bought battered mortgage securities, including Marathon Asset Management, an $11.5 billion hedge fund manager specializing in distressed assets; Trust Company of the West, with $160 billion with assets under management, and Metropolitan West Asset Management, with $27 billion in assets, as well as U.K.-based investment boutique, Thames River.

PRIME TIME FOR SUBPRIME BONDS

“We’re not finding any problems finding opportunity,” said Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles.

The Alt-A mortgage securities, as well as the ones purchased by Gundlach, which are loans whose quality rests in the vast space between subprime and prime, and subprime mortgage-backed securities “are as rich an opportunity set as the corporate market was back in 2002 when the bubble burst in telecom,” Rivelle added.

Bruce Richards, chief executive officer of Marathon Asset Management in New York, told Reuters recently that his firm has purchased more than $1 billion par value in residential real estate loans. Richards also said that he expects Marathon to buy another $1 billion or more this year.

Thames River Capital fund manager Ken Kinsey-Quick has moved long into some battered subprime assets after shorting the sector last year.

Kinsey-Quick, who runs around $2.3 billion in funds of hedge funds, said he had invested in the securities at the start of April because he thinks they are cheap.

For his part, Rivelle of MetWest will be looking at the Alt-A market, but for now he’s been a purchaser of the safest part of a subprime bond that typically gets paid off in full, even in foreclosure.

“Even if there was a substantial and rapid rise in foreclosures and delinquencies in these deals, the rub is the servicer sells the property and generates some amount of cash in the process,” Rivelle said.

This cash flow gets directed to these ‘AAA’ securities, causing them to be repaid at an accelerated rate, he added.

As for those bonds that Gundlach bought at 65 cents on the dollar: “They looked great at 65 and at 80, they look kind of fully priced against the fundamentals.”

WAITING FOR THE FORCED SELLING

Truth be told, risks to investing now rather than later persist.

Downgrades of bonds backed by subprime loans by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings continue apace as expectations of falling home prices have led rating companies to boost expectations on delinquencies.

Subprime loan default rates have more than doubled to 25 percent this year, and will climb above 30 percent by December as a worsening job market adds stress to homeowners already faced with unaffordable mortgages, according to Friedman Billings Ramsey Inc. research.

Credit Suisse on Tuesday boosted its forecast of subprime foreclosures over the next two years to 1.39 million from its October estimate of 730,000.

“We’re certainly looking (at distressed assets), though we think that a lot more downgrades are coming that will result in substantial supply from forced sellers,” said Julian Mann, a manager of mortgage- and other asset-backed bonds at First Pacific Advisors in Los Angeles, California.

Gundlach doesn’t doubt that, saying, “The fundamentals in housing are still terrible. You better believe there will be downgrades coming.”

At that point, he’ll be looking to buy again, he said.

(Additional reporting by Dane Hamilton in New York and Laurence Fletcher in London)