GSE bailout could come back to bite mortgage rates

NEW YORK (Reuters) - The U.S. government's historic bailout of Fannie Mae (FNM.N) and Freddie Mac (FRE.N) may eventually end up raising mortgage rates instead of lowering them.

Interest rates on 30-year fixed-rate mortgages plunged this week, following the government's takeover of the mortgage giants last Sunday.

The move to recapitalize the two U.S. government-sponsored enterprises, or GSEs, which own or guarantee nearly half of the country's $12 trillion in outstanding U.S. mortgages, could help homeowners avoid foreclosures through home loan refinancing and entice potential home buyers.

But in the longer term mortgage rates may end up moving in the opposite direction as the government may be forced to borrow more to implement its plan to finance Fannie Mae and Freddie Mac and buy mortgage backed securities (MBS) in the open market, according to some analysts.

"If the government injects capital into Fannie Mae and Freddie Mac that should add Treasury supply, which could end up pushing mortgage rates higher," said Torsten Slok, senior economist at Deutsche Bank in New York.

"That would actually end up having the reverse effect of what Treasury Secretary Paulson wants," he said.

U.S. Treasury Secretary Henry Paulson said one of the main motivations behind seizing Fannie Mae and Freddie Mac was to support the U.S. housing market, currently suffering the worst downturn since the Great Depression.

The bailout plan announced last Sunday enabled the U.S. Treasury to take up to $100 billion in senior preferred stock of both Fannie Mae and Freddie Mac.

To help fund the GSE capital infusion and buy MBS issued by the two agencies, the government will probably issue debt, which should pressure prices on benchmark Treasury securities. Mortgage rates are priced off benchmark U.S. Treasury yields.

MORTGAGE RATES FELL AFTER BAILOUT

Freddie Mac said on Thursday interest rates on U.S. 30-year fixed-rate mortgages fell by 0.42 percentage point in the latest week, the biggest weekly drop in more than 28 years.

Interest rates on the 30-year fixed-rate mortgage averaged 5.93 percent for the week ending September 11, down from the previous week's 6.35 percent, an almost five-month low.

"Mortgage rates tend to be correlated with Treasury yields and that correlation broke down in the summer, but it returned somewhat as a result of the government takeover," said Greg McBride, senior financial analyst at Bankrate, Inc, in North Palm Beach, Florida.

The spread between the 30-year fixed-rate conforming mortgage rate and 10-year Treasury yield was at a 22 year high for several weeks prior to the U.S. government bailout, he said.

"Investors may get nervous about how much debt the Treasury will be taking on and any rise in Treasury yields could dilute some of the impact that the takeover had on mortgage rates initially," he said.

The U.S. government's bailout of Fannie Mae and Freddie Mac could be the costliest in history. No forecasts have yet surfaced on the amount of Treasury issuance required to cover the cost. Bill Gross, chief investment officer of Pacific Investment Management Co., which manages the world's biggest bond fund, estimated the initial costs would be around $50 billion, while the Treasury itself has committed up to $200 billion for the plan.

Longer-dated Treasury prices have fallen in recent days, with yields rising, partly due to the prospect of increased U.S. government debt issuance to pay for the takeover of mortgage finance companies Fannie Mae and Freddie Mac, according to T.J. Marta, fixed income strategist at RBC Capital Markets in New York.

"The whole notion of the GSE bailout is going to lead the longer end of the yield curve higher. People are still mulling that over," he said.

David Beadle, president, BestInfo, Inc., a mortgage-industry consulting company in Dover, Vermont, said higher mortgage rates may be inevitable.

"The decision by the U.S. Treasury to place the GSEs into conservatorship could turn out to have been the biggest blunder yet in the ongoing saga of the credit crunch," he said.

Beadle, who tracks mortgage rates on a daily basis, said foreign central banks could end dumping devalued U.S. mortgage and Treasury holdings, forcing the government to pay dramatically higher yields to attract cash at weekly and monthly Treasury auctions.

"The result would be a return to the high double-digit domestic mortgage rates seen during the inflation spiral of 1981," he said.

HOUSING IS STILL HURTING

Eric Belsky, executive director at Harvard University's Joint Center for Housing Studies, said while the government bailout of the GSEs had an immediate impact on mortgage rates, the U.S. housing market faces other important issues.

"The biggest benefit of the government GSE bailout is that it keeps credit flowing, which is essential to housing, but there is still a lot weighing on the housing market," he said.

"Foreclosures increased in the second quarter and that will put further downward pressure on prices and impact the mood of consumers," he said.

The Mortgage Bankers Association said last week U.S. home foreclosures and the rate of homes entering foreclosure rose to record highs in the second quarter.

"The big issues are still falling home prices and an oversupply of homes for sale," he said.

(Additional Reporting by Pedro da Costa and John Parry)