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ANALYSIS - Fannie, Freddie buyouts rattle U.S. mortgage bonds

NEW YORK (Reuters) - Major policy shifts on treatment of defaults in mortgage-backed securities by Fannie Mae and Freddie Mac may lead investors to demand higher yields in months ahead, pushing rates upward for consumers.

Investors on Thursday were scrambling to understand the impact on their portfolios after the two U.S. housing giants said they will repurchase some $200 billion in delinquent home loans that Fannie and Freddie have guaranteed. By doing so, it will speed the early return of mortgage principal to investors in a “prepayment,” an unwanted event for many bondholders.

Chaotic trading, with pension funds and other institutional investors rotating out of mortgage bonds in the path of repurchases, is an ominous sign for the $5 trillion market that supplies the lion’s share of money for U.S. housing. Investors are already on edge as they face the planned break of emergency support from the Federal Reserve next month.

Most of the increased uncertainty is due to Fannie Mae’s policy of buying loans from MBS beginning in March, and over the course of a few months. Freddie Mac’s purchases will be done at once from securities held by investors this month.

“There is tremendous price fluctuation,” said Scott Simon, head of mortgage- and asset-backed portfolio teams at Pacific Investment Management Co. in Newport Beach, California. “It creates tremendous uncertainty ... no one knows what to do.”

Betting Freddie Mac bonds would perform better than Fannie Mae’s was one common trade, but it was unclear if it will last. Pimco, manager of the largest bond mutual fund, already bought the “swap” at 4-1/4 points and sold it at 4-18/32, Simon said.

An accounting change that put MBS on-balance sheet led the companies to reassess when they will buy the rising number of delinquent loans out of securities. Decisions on what would be more costly -- write-downs on buyouts from off-balance sheet MBS, or advancing payments to investors -- became clear.

Reducing costs this way will help preserve capital at the companies and cut their reliance on taxpayers to support their businesses of guarantees and investments in U.S. mortgages.

Investors were surprised by the buyout announcements despite growing expectations since December, according to Credit Suisse analysts. In a buyout, the investor gets a prepayment at face value of $100, which is good for bonds trading below $100 and harmful for those over $100.

Greater prepayment uncertainty combined with the Fed’s exit from the market may raise volatility in MBS and force yields higher, said Chris Sullivan, chief investment officer at the United Nations Federal Credit Union in New York.

“Volatility should also increase as we move closer to the Fed’s planned monetary tightening -- the effect of such should also increase risk premiums and consequently consumer mortgage rates,” Sullivan said.

Freddie Mac by making its buyouts in one move handed an immediate loss to many investors who held bonds that were trading at $106 or higher. But it also clarified the outlook for their bonds in coming months.

“Investors who hold mortgages this month will suffer a one-time loss, and there’s no way to avoid it,” said analysts at Amherst Securities Group, in a report late on Wednesday.

The larger Fannie Mae left the door open in terms of timing of the rise in the principal prepayments. This means Fannie Mae MBS will be harder to quantify for a time, Amherst said.

Investors flooded bond traders on Thursday with requests to sell bonds paying high interest rates since they are typically to borrowers with weaker credit histories, and thus more likely to default. With prepayment rates low, many investors had decided to take the risk of owning those bonds for their high coupon payments.

“It’s just plain crazy,” said one strategist at a New York primary dealer. “The down-in-coupon trade is on fire. The up-in-coupon is getting crushed.”

But Credit Suisse and other dealers expected the buyout announcement to benefit the MBS after the buyout periods end. Prices can move higher after the next few months as delinquent loans are cleared, said Scott Buchta, a strategist at Guggenheim Capital Markets in Chicago.

Principal returned to investors may be reinvested into a market where new issuance is expected to drop.

Still, some portfolio managers are not counting on greater demand since investors, such as the Fed and probably not Fannie Mae and Freddie Mac, are unlikely to reinvest. More than half of the estimated $200 billion paydown will be in hand that will not buy them back, Pimco’s Simon said.

Todd Abraham, co-head of government and mortgage-backed bond groups at Federated Investors in Pittsburgh, Pennsylvania, said Fannie Mae could take steps to smooth trading. Fannie Mae on Wednesday said it would provide more information on its securities within two weeks.

“I would expect, in relative short order, that Fannie Mae will clarify it,” he said. “If you want them to trade better, transparency is a help to the market.”