U.S. mortgage bailout faces tough deadline to end crisis

NEW YORK/LONDON (Reuters) - The U.S. government bailout of Fannie Mae and Freddie Mac has the potential to break the vicious circle prolonging the year-old global credit crunch, but there is a tight 15-month deadline for the plan to work.

Few analysts expected Sunday's plan by the U.S. Treasury to take control of the mortgage finance giants, which together own or guarantee about half of the country's $12 trillion in mortgages, to turn around the worsening U.S. or global economy overnight.

The initiative appears to be a bold one and includes a plan by the Treasury to begin buying mortgage-backed securities issued by the two companies this month. However, the credit line will only be in place through the end of next year.

This 15-month deadline is critical and it is still unclear whether that will be enough time to foster a U.S. housing market recovery before the mortgage agencies are reduced in size and their future decided in 2010.

"That is part of the pressure and will ultimately be the success or failure of what Treasury has outlined," Kevin Giddis, managing director of fixed income at Morgan Keegan in Memphis, Tennessee, said about the time constraints.

"There are plenty of questions out there and adding the deadline is just going to add to the pressure."

The immediate reaction in financial markets on Monday was exactly what the moribund U.S. housing market will need to begin pulling out of its funk.

Fannie Mae and Freddie Mac bond prices soared and mortgage backed securities (MBS) prices jumped, allowing the 30-year fixed-rate home mortgage rate to fall to near 6.00 percent on Monday from 6.50 percent on Friday, according to Greg McBride, senior financial analyst at Bankrate, Inc, in North Palm Beach, Florida.

Sunday's U.S. government announcement also caused stocks to rise around the world and the U.S. dollar to surge on Monday.

EYE OF THE STORM

However, the plan's deadline could undermine its benefits, some analysts said.

"The lack of clarity about what will happen after 2009 may impair the return of confidence in MBS," said Ciaran O'Hagan, fixed income strategist at Societe Generale in Paris. "The key question now is what happens when the measures of support run out in 2009."

With an economic slowdown now spreading around the world and recession looming in Europe and Japan, the cycle of falling home prices, restricted bank lending, and rising unemployment will take some time to play itself out, but there is no question that the two government sponsored enterprises are at the center of the problem in the U.S.

To the extent that the root of the global credit crisis lies squarely in the drying up of U.S. mortgage finance, then using the U.S. mortgage behemoths as a fountain of liquidity to support the housing market may well work.

"They have short-circuited a potential chaotic development or catastrophe," Kevin Logan, senior U.S. economist at Dresdner Kleinwort in New York, said about Treasury's plan.

"Now the Treasury is channeling money through the GSEs into the mortgage market to lend money to people to buy houses. So at the margin mortgage rates will come down and there will be more credit available."

Since their peak in 2006, U.S. house prices have fallen by nearly 20 percent as loose lending standards resulted in rising mortgage foreclosure rates, adding to the supply from a construction boom.

Most analysts agreed that the primary focus of the plan was to reduce mortgage costs, which would help stop the fall in house prices by allowing borrowers to refinance onerous loans and encouraging new buyers into the market.

This could help the troubled banking sector by bringing down credit losses at heavily leveraged lenders and ultimately encourage investors to start buying riskier assets once again.

Reaction to the plan suggested some pieces of this puzzle were already falling in place.

Monday's sweeping rally in mortgage backed securities , inspired by the government's plan to buy MBS and recapitalize Fannie and Freddie, helped banks recoup $20 billion on their holdings of such investments, said Matthew Jozoff, head of mortgage strategy at JPMorgan, on a conference call.

That's a drop in the bucket compared to the more than $500 billion in credit losses and write-downs financial firms overall have posted since credit markets seized up a year ago after defaults on U.S. home loans, but it's a start.

"IMPRESSIVE"

Fannie Mae and Freddie Mac, the two largest sources of U.S. housing finance, had suffered combined losses of nearly $14 billion in the last four quarters. Large holders of their debt, including overseas central banks, began to get increasingly nervous about their financial health.

So as part of the plan, the Treasury took $1 billion of preferred senior stock in each company to boost their capital but its equity stake could reach as much as $100 billion in each and will be senior to both existing preferred and common shares.

Jim O'Neill, chief global economist at Goldman Sachs in London, said the plan was "impressive."

But the plan envisages government support for Fannie Mae and Freddie Mac lasting only until the end of 2009, when final decisions about the size of their activities will have to be made.

And the economic context of a "severely impaired housing market" and damaged financial system has not changed, nor has the newer problem of economies outside the U.S. slowing, O'Neil said.

"Questions are likely to be asked about what happens after the end of 2009 when Treasury authority is currently planned to end and a planned gradual contraction in GSE assets begins," he added.

But, O'Neill did see a positive twist: "By this time, however, the housing market is likely to have stabilized."

(Writing by Mike Dolan in London and Burton Frierson in New York; Additional Reporting by Lynn Adler and Julie Haviv in New York)