Govt ties trump US agency debt supply rise in 2010

NEW YORK Dec 30 (Reuters) - U.S. government support for Fannie Mae and Freddie Mac should keep a lid on their debt yields in 2010, even if bond issuance rises to help mend the housing market.

Agency debt rallied dramatically in 2009 thanks to massive government support that will remain for the next three years, even as a key backstop, the Federal Reserve's program to buy these securities, will end in March.

The Treasury gave the markets peace of mind on Dec. 24 by opening credit spigots to the two mortgage finance companies and giving them more purchasing power by amending a demand for the companies to cut their mortgage-related investment portfolios. Read more at [ID:nN24191767].

"An unlimited backstop for three years is massive government support and yield-spread positive," said Margaret Kerins, strategist at RBS Securities in Chicago. "It should ease international investor concerns especially for debt maturing in three-years and under."

The ongoing support takes the sting out of the Fed's withdrawal as the biggest investor. Fed buying of agency and mortgage debt dominated markets in 2009 as the U.S. central bank intervened to try to resuscitate lending markets.

The Fed's program to buy about $175 billion of Fannie Mae FNM.N, Freddie Mac FRE.N and Federal Home Loan Bank System (FHLB) notes will end March 31. Those purchases, along with $1.25 trillion of mortgage bonds, slashed yield spreads.

In the Fed-induced rally, risk premiums on 2-year Freddie notes sank to about five basis points over Treasuries from 195 basis points on Nov. 20, 2008, before Fed buying began.

Spreads tumbled to about 7 basis points on 5-year notes and 17 basis points on 10-year debt from November 2008 peaks between 160 and 170 basis points, respectively.

There is a possibility that net issuance will rise in 2010, which could pressure prices and force yields higher. But more likely, net issuance will fall for a third straight year, helping keep yield spreads relatively meager.

"The stepped-up level of Treasury support, while not the equivalent of full faith and credit backing, argues for yield spreads remaining tight," said Nancy Vanden Houten, analyst at Stone & McCarthy Research Associates.

Still, borrowing needs are somewhat of a wildcard after the Treasury amended its mandate for steep annual mortgage portfolio cuts by Fannie and Freddie starting next year.

In another effort to keep broad supports under the fledgling rebound in housing, the companies' mortgage holdings can actually grow next year.

Originally, rules called for them to shed 10 percent from the amount they each hold at the end of 2009 -- $752 billion for Fannie and $762 billion for Freddie as of Nov. 30. Now, they have to cap their portfolio at $810 billion at the end of 2010, and cut 10 percent each year after.

NEITHER ACTIVE BUYERS NOR SELLERS

"To meet this goal, Treasury does not expect Fannie Mae and Freddie Mac to be active buyers to increase the size of their retained mortgage portfolios, but neither is it expected that active selling will be necessary to meet the required targets," the Treasury Department said in a statement.

A pivotal unknown is the amount of modified home loans the two companies will have to buy out of securities pools that may count toward their portfolio sizes. Wall Street estimates start at $160 billion, more than five times the amount this year.

Freddie Mac spokesman Michael Cosgrove had no comment on what the Treasury action means specifically for new funding.

Devajyoti Ghose, vice president of debt and liquidity management at Freddie Mac, does expect the trend of "terming out," or replacing short-term and callable debt with longer-term funding, to continue.

"We expect there will be a fair bit of gross issuance, although I don't expect it to be as much as this year," he said. A chunk of the gross supply will be issued to replace about $125 billion of long-term debt that is maturing as well as bonds that are called, he said.

Fannie Mae mortgage debt outstanding is expected to shrink by 3.4 percent in 2010, which would be the third straight annual drop, according to Fannie Mae's most recent forecast.

"The core theme is the flexibility of their issuance plans and their ability to stay out of the parts of the market that are perhaps most expensive for them," FTN Financial analyst Jim Vogel said of the agencies' debt funding programs.

Morgan Stanley analysts expect gross issuance to drop 13 percent to $1.8 trillion in 2010. Net issuance is expected to fall by $45 billion in 2010, which would follow a decline of $509 billion in 2009.

FHLB System issuance should shrink by about 10 percent also, Morgan Stanley projects. (Editing by Leslie Adler)