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(Adds Rep. Barney Frank statement, letter to SIFMA)
By Al Yoon
NEW YORK, Aug 14 (Reuters) - Fannie Mae and Freddie Mac can include, but must limit, the number of large mortgages packaged into bonds in a key part of the market to help contain costs for struggling U.S. housing borrowers, an industry group ruled on Thursday.
Fannie Mae and Freddie Mac, the largest providers of U.S. home loan funding, may for the first time use larger loans as collateral for up to 10 percent of bonds in the first stage of the $4.5 trillion "agency" mortgage-backed securities market, an association of bond dealers and investors said.
Shares of Fannie Mae FNM.N and Freddie Mac FRE.N rose more than 7.0 percent, also bolstered by gains in financial stocks, analysts said. For stock story, see: [ID:nN14517758].
The decision by the Securities Industry and Financial Markets Association (SIFMA) follows sweeping U.S. housing legislation that permanently boosted limits on loans eligible for Fannie Mae and Freddie Mac programs to $625,550 from the base of $417,000. Lawmakers expected the bill would make it easier for more Americans to get a mortgage.
The SIFMA move allows for some loans in excess of the old limits on eligible loans to be packaged into securities for sale to investors in the "to-be-announced" (TBA) mortgage bond market, an important avenue for U.S. lenders to raise money for residential mortgages.
The new policy applies to Ginnie Mae as well as Fannie Mae and Freddie Mac.
The TBA market's liquidity lowers yield premiums and as a result lowers the mortgage rates lenders can offer on loans they sell into the market.
"This arrangement preserves the overall homogeneity of the market while at the same time minimizing the risk of a negative impact on mortgage rates for lower balance loan borrowers, or, potentially, all borrowers," said Sean Davy, a managing director at SIFMA in New York.
Debate over whether to allow the larger loans in the TBA market, limit the inclusion, or exclude them completely caused a schism among market participants, sources said.
Including the loans, formerly in the "jumbo" category, could increase interest rates on smaller mortgages, but excluding them would reduce the effect that Congress desired in stabilizing housing markets in costly regions, House Financial Services Committee Chairman Barney Frank said in an Aug. 12 letter asking SIFMA to allow all large loans be TBA-eligible.
Rates on larger loans made eligible for Fannie Mae and Freddie mac programs under earlier legislation, but excluded from the TBA market by SIFMA, remain high, he said in the letter.
"This move should help to reduce the cost of mortgages to borrowers in high-cost areas without any negative effect on rates for smaller loans," Frank said in a statement on Thursday. "We will continue to work with SIFMA on this going forward, but this is a very important first step."
Traders were concerned that allowing larger loans into the TBA market would be tampering with a market that has become a more crucial source of home loan funding since the credit crunch set in last year. The bonds make up a third of many "government" mutual funds.
The inclusion of large loans may have an outsized affect on TBA bonds since investors do not know what collateral is in their bonds and assume they will receive securities with the worst-possible characteristics.
"People in the MBS market are conditioned to shun larger-sized loans because of their bad prepayment characteristics," said Nicholas Strand, a strategist at Barclays Capital in New York. "So I think initially people thought this could potentially be a bad outcome for TBA."
The larger the loan, the more apt it is to be refinanced when rates are attractive. Faster-than-expected prepayments when rates are falling reduce the value of a mortgage-backed security (MBS).
Agency MBSs, which trade separately from the subprime mortgage bonds that sparked the credit crisis, have slumped in price since May on concern that capital-constrained investors like Fannie Mae and Freddie Mac would cut their demand.
Uncertainty over the SIFMA decision influenced the weakness, though the impact was muted in recent days.
An analysis by Barclays Capital found that even full inclusion of large loans would have a negligible impact on the TBA market since only 15 percent of existing jumbo loan borrowers will qualify under the new loan limits.
Issuers will pool other larger loans into securities, but they will not be eligible for TBA trading. (Additional reporting by Lynn Adler and Julie Haviv in New York, and John Poirier and Patrick Rucker in Washington)