Watershed event for $8 trillion in MBS, agencies unfolds

Secretary of the Treasury Henry Paulson (L) and Jim Lockhart, Director of the the new independent regulator, the Federal Finanace Agency (FHFA), announce that the government is taking control of mortgage finance companies Fannie Mae and Freddie Mac during a news conference at the Office of Management Supervision in Washington, DC, September 7, 2008.

NEW YORK (Reuters) - A vast $8 trillion portion of the U.S. credit markets is expecting a big jolt this week after investors in mortgage-related debt on Sunday found a new heavyweight by their side -- the U.S. government.

The U.S. Treasury's takeover of Fannie Mae and Freddie Mac over the weekend is a watershed event for the mortgage-backed and "federal agency" debt markets which have grown into the most actively traded debt markets in the world, next to U.S. Treasuries, since the 1980s.

The government, seeking to thwart a loss of confidence in the two companies which are the key to the U.S. housing market, has officially switched its support for Fannie Mae and Freddie Mac from implicit to explicit.

The move should boost the prices of debt issued or guaranteed by the companies which has been a staple of bond portfolios from hedge funds to pension funds, insurance companies and conservative mutual funds.

"What you will see is a tremendous rally in MBS and in agency bonds, which in turn will help other credit related" debt," said Andrew Harding, director of taxable fixed-income investing at Allegiant Asset Management in Cleveland, Ohio.

For the $4.5 trillion mortgage backed securities (MBS) market, where Fannie Mae, Freddie Mac and the government have guaranteed bonds backed by home loans, the support from Treasury comes after a prolonged slump in prices.

The bonds have begun to lose key sources of demand and have posted only anemic rallies since March when valuations plunged to depths not seen in more than two decades.

Debt markets, rather than the companies themselves, are clearly the concern of the U.S. Treasury, since the takeover plan dealt a blow to shareholders and will chances for profit growth in the future. Allowing for modest portfolio growth through 2009, the Treasury conservatorship demands the companies holdings decline 10 percent a year until they reach $250 billion, a third of their current sizes.

Leveraging low borrowing costs achieved with an implicit government backing had earlier allowed Fannie Mae and Freddie Mac portfolios of MBS and other securities to more than double since 1998 to a combined $1.5 trillion.

MORTGAGE RATES SEEN DROPPING

Falling demand for mortgage bonds increased their yield premiums to ultra-safe Treasuries by nearly a full percentage point to 2.13 percentage points in mid-August from May. The average 30-year mortgage rate over that time climbed 0.75 point to 6.57 percent, and has hovered near there despite a drop 10-year Treasury rates, another key influence.

But the Treasury now expects to purchase $5 billion of Fannie Mae and Freddie Mac mortgage bonds within the next month.

"Mortgage rates should drop on this," said Brian Gardner, senior political analyst, at Keefe, Bruyette and Woods. "This will add liquidity to the companies and rates should decline."

Agency bonds, which are used to fund the investments of Fannie Mae and Freddie Mac, should also get a boost relative to Treasuries given the new government backing, said Jim Vogel, a strategist at FTN Financial in Memphis, Tennessee. Limited liquidity, or funds, in the system may limit big purchases, however, he said.

The $3 trillion market is the source of funds for Fannie Mae and Freddie Mac investments, the more controversial side of their business since the companies have taken greater risks with purchases in recent years.

Fears of a pullback in demand for MBS by the capital constrained companies has been a key factor in the weakness in the market, along with signs that crucial support of foreign central banks was waning.

The reason for the bailout "is a problem that started 15 years ago, when they started expanding their portfolios beyond their mandate of insuring and purchasing conforming loans," Allegiant's Harding said. "They became a very large hedge fund."

Treasury support of more than agency debt and guarantee obligations of Fannie Mae and Freddie Mac may lead investors to push U.S. borrowing costs higher, however. The Treasury has doubled its outstanding, marketable obligations, with riskier assets, analysts said.

Rating company Standard & Poor's on Sunday affirmed that the agency senior debt would keep the same "AAA" rating as U.S. Treasuries. It also switched its ratings outlook on the subordinated debt of the companies after the Treasury, to some investor surprise, left their interest payments intact while eliminating dividends on similar risk preferred stock.

"The biggest winners, in order, are sub debt holders, MBS holders -- with a big boost possibly coming from direct Treasury MBS purchases, which I hadn't expected -- and senior debt holders," Thomas Lawler, a former Fannie Mae portfolio manager and founder of Lawler Economic & Housing Consulting in Leesburg, Virginia, said in an e-mail.

Subordinated debt yield spread premiums ballooned by more than 2 percentage points in a single day in mid-August to about 6 percentage points after Barron's asserted a government intervention was near and would not spare the bonds.

But the Treasury's conservatorship may trigger financial insurance contracts on subordinated debt, prompting holders of the "credit default swaps" to demand payment, one investor said. Subordinated debt values will depend on analyses of how protected it will be in the future, he said.

(Additional reporting by Lynn Adler in New York)