Could TARP smother, not shield, U.S. housing?

By Lynn Adler - Analysis

NEW YORK (Reuters) - The U.S. government's plans to sop up soured assets from shell-shocked banks to reignite lending could have an unintended consequence: raising mortgage rates and deepening the housing crash that touched off the crisis.

Average fixed 30-year mortgage rates rocketed nearly half a percentage point higher last week, their biggest one-week spike in more than five years, to 6.47 percent, according to the Mortgage Bankers Association.

The rates galloped higher as investors dumped U.S. Treasuries ahead of what they fear will be a flood of government debt to pay for the bank rescue program. That drove up yields on the securities used to peg mortgage rates.

Economists question how quickly TARP, or the Troubled Asset Relief Program, will have the intended result of freeing up banks to extend more loans and whether it will lower costs.

"The jury is still out," said Greg McBride, senior financial analyst at Bankrate in North Palm Beach, Florida. "It could just as easily go the other way, with all the concerns about additional debt issuance by the Treasury actually pushing Treasury yields and mortgage rates higher."

TARP is part of the $700 billion U.S. government bailout package, which includes plans to buy toxic mortgage assets from banks and directly infuse them with capital.

Analysts cite other factors that could drive up home loan rates for some time, including an unusually large gap between 10-year Treasury yields and 30-year mortgage rates and the near record risk premiums demanded by investors on mortgage securities.

Nervous investors keep demanding lofty yields on mortgage bonds versus low-risk Treasuries, raising costs for mortgage lenders who pass along the increase to home buyers.

The spread between the 10-year note and 30-year home loan has hovered around 260 to 280 basis points, at least 100 basis points above its typical level prior to the credit crisis, McBride said. In the new world of tight lending, the spread will stay over 200 basis points even after the crunch passes, he said.

"There are so many problems in fixed-income in general right now and I am not sure the mortgage market will benefit first," said Adam York, economic analyst at Wachovia Corp in Charlotte, North Carolina.

The markets need to sort through a host of global rescue operations, many of which are still in the planning phase. One of the key unknowns is how the so-called toxic, untraded mortgage assets will be priced when they are sold to the government.

"Eventually it will help," Doug Duncan, Fannie Mae (FNM.N) chief economist, said of TARP. "It's not the be-all, end-all. It takes time to get the operational aspects functioning and to actually see some real-time transactions, to learn the pricing, figure out what that means for other assets that might be eligible."

LENDING SLOW TO THAW

Pumping the banking sector with liquidity while the economy falters would typically lift sentiment, lowering bond yields and thus mortgage rates. However, the reverse is happening.

Blame a ballooning budget deficit, wrote Mike Larson, real estate analyst at Weiss Research in Jupiter, Florida, in his blog. The U.S. budget gap more than doubled to a record $455 billion in fiscal 2008 which ended in September, and will sprint higher in 2009.