Watershed event for $8 trillion in MBS, agencies unfolds

By Al Yoon - Analysis

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.