Mortgage rescue could hurt and help U.S. municipals

NEW YORK (Reuters) - The U.S. government's bailout of Fannie Mae FNM.N and Freddie Mac FRE.N could bolster the $2.6 trillion municipal market by halting the housing market's slide but state housing bonds could be hurt if the companies opt to sell their holdings, analysts said Monday.

The bailout announced Sunday is expected to stem the tide of foreclosures and mortgage defaults and lift state and local economies, reviving property, sales and income tax revenues.

But Fannie Mae and Freddie Mac will also be obliged to slash their portfolios, which include billions of dollars of state housing bonds.

The immediate impact in the muni market Monday was in the obscure area of pre-refunded issues.

States, cities, hospitals and turnpikes have to buy secure assets that are placed in escrow when they refinance debt. Prices of pre-refunded bonds that were backed by agency paper shot up, said Tim McGregor, director of municipal fixed income at Northern Trust in Chicago.

Spreads for some pre-refunded issues backed by Fannie Mae and Freddie Mac were halved from 50 basis points or so on Friday.

"People are still trying to buy them at last week's levels; that's not going to happen," he said.

Funds and housing authorities welcomed the move to strengthen Fannie Mae and Freddie Mac, which will boost the debt they backed.

Clark Stamper, chief investment officer at Stamper Capital & Investments in Corona del Mar, California, said certain muni housing bonds secured by Fannie Mae and backed with mortgages probably traded up on the news of the takeover.

Prior to the news, the bid on those bonds, which involved newer mortgages, was weak, he said.

The Ohio Housing Finance Agency agreed. "If anything it should make them stronger," spokeswoman Erin Biehl said in an e-mail.

SLIM PROFITS MAY SPUR SELLING

Philip Lentz, director of communications for the New York State Housing Finance Agency, was one of several experts who saw a risk that Fannie Mae and Freddie Mac will no longer need to shield profits with tax-free debt.

"Under the conservatorship, the question is will they be paying taxes any more? If they're not a profit-making company any more then they wouldn't really need to have any tax-exempt investments to offset income," said Lentz.

Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors, noted that the two mortgage behemoths had scaled back purchases of state housing bonds in the last year.

Some state housing agencies could feel the pinch of a drop in demand. The Ohio agency, for example, said a third of its loans went to Fannie Mae from January to June.

And government-sponsored enterprises, which includes Fannie Mae and Freddie Mac, owned about $32 billion of state housing bonds when the first quarter ended, said Fabian, citing Federal Reserve data.

Adding to the risk of selling is the drastic cuts planned for both mortgage companies' portfolios. Under the terms of the bailout, the companies can add $2 billion to the total of $1.5 trillion they own from now until the end of 2009. But they must then cut their holdings at a rate of 10 percent a year until they reduce them to $500 billion.

The state housing agencies with the most to lose are the ones that custom tailored their debt for Fannie Mae and Freddie Mac, by offering unusual coupons instead of the always popular 5 percent rate, Fabian said. Buyers might demand steep discounts for this sort of oddball debt, Fabian said.

"However, by all appearances, this should be gradual and, outside of the housing sector, is unlikely to pose much threat to generic muni spreads," he said in a report.

(Reporting by Karen Pierog in Chicago, Lisa Lambert in Washington, D.C., and Joan Gralla in New York; Editing by Leslie Adler)