Fannie, Freddie bailout greeted with cautious optimism

NEW YORK (Reuters) - U.S. mortgage rates fell on Monday after the government seized control of Fannie Mae and Freddie Mac, raising hopes the plan would provide at least temporary respite from troubles in housing and credit markets.

Stock prices rallied around the world as investors felt that federal backing could stem some of the pain that has crippled the financial system for over a year.

However, the bailout of the country's two biggest mortgage finance companies, which may prove the costliest ever, was a still a symptom of the dismal state of capital markets more than a year into the crisis, analysts said.

The immediate reaction to the U.S. government's commitment of up to $200 billion to support the two giant mortgage lenders, which together back about half the country's $12 trillion in mortgages, was positive.

Thirty-year mortgage rates fell about a half percentage point from Friday to 6.0 percent, according to Bankrate.com, helped in part by the Treasury's decision to buy mortgage-backed securities issued by Fannie Mae and Freddie Mac.

The Dow Jones industrial average surged 293.52 points or 2.6 percent, while the FTSEurofirst stock index closed up 3.3 percent.

"The Treasury's announcement that it will place the government sponsored enterprises into conservatorship and purchase agency mortgage-backed securities is a very positive step for the housing market and the broader economy," said Jan Hatzius, economist at Goldman Sachs.

The stocks of Fannie Mae and Freddie Mac themselves plunged over 85 percent though, since the Treasury's plan explicitly ruled out any protection for existing shareholders. After losing most of their value in the past year, the stocks were around 70 cents per share on Monday.

With the two companies' bondholders likely to be long-term beneficiaries of the takeover, the yield premium on the agencies' debt against Treasury bonds narrowed by as much as 40 basis points, traders said.

"This is the biggest event in my 21 years in the business," said Arthur Frank, director and head of mortgage-backed securities research at Deutsche Bank.

Government bonds initially suffered as investors bet the bailout would vastly increase Treasury borrowing. Yields on two-year U.S. Treasury notes jumped almost a half percentage point. Treasuries eventually made a come back, however, as mortgage investors adjusted their portfolios to the new, government-backed reality by buying long-dated debt.

PRICE TAG UNCLEAR

Stock market behavior itself hinted at investors reservations about the plan though, with major indexes closing beneath session highs and the day's trade plagued by volatility.

U.S. President George W. Bush said the action had been necessary because troubles at Fannie Mae and Freddie Mac, which have $1.6 trillion in debt outstanding, posed "an unacceptable risk to the broader financial system and our economy."

But Treasury Secretary Henry Paulson, in a number of television appearances Monday, said he could not estimate how big a burden the government's support for the two companies would be on the taxpayer until the extent of declines in the mortgage market were fully known.

The plan tries to protect taxpayers by ranking the government new equity stake in the firms above existing shareholders and installing new management. Even with all these provisions, analysts said the potential pitfalls were numerous.

"This euphoria might fade, because Fannie and Freddie are not the problem," said Christopher Low, chief economist at FTN Financial. "Their woes are a symptom of a worldwide contraction in credit that may not be cured by the decision."

The takeover of Fannie and Freddie came amid heightened worries about shrinking capital at the congressionally chartered companies, which had combined losses of nearly $14 billion the last four quarters.

Financial firms have also posted more than half a trillion dollars in losses and write-downs related to the mortgage and credit crises in the past year.

In July, Paulson had hatched a plan to shore up the firms with a promise of fresh loans and a government injection of capital if either company was pushed to the brink of collapse.

But talks on an aid package ended abruptly in the past few days and policy-makers decided to seize the firms, industry sources with knowledge of the events said.

Large holders of the two companies debt, including overseas central banks, had shown increasing nervousness recently, dumping more than $27 billion in agency securities in just the last two months. China and Japan, the biggest buyers of the two companies' bonds, welcomed the bailout.

Analysts noted this was only the latest in a string of rescue plans for banks and for the two government sponsored enterprises though, none of which had achieved lasting success.

"The rapid tide of the financial market deterioration combined with the persistent escalation in unemployment has managed to overwhelm the effectiveness of these interventions," said Ashraf Laidi, chief FX strategist at CMC Markets US.

(Reporting by Pedro Nicolaci da Costa and Julie Haviv, Editing by Chizu Nomiyama)