The Paulson Effect: A rush into Fannie and Freddie bonds

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For one day, at least, Henry Paulson is the toast of financial markets worldwide.

The U.S. Treasury chief’s rescue plan for mortgage giants Fannie Mae and Freddie Mac had the desired effect on Monday, driving down the companies’ borrowing costs and opening the door to lower mortgage rates.

That fueled a powerful rally on Wall Street and gave another big boost to the dollar. Before the opening bell in New York, stocks also had surged around the world on hopes that the U.S. might finally be getting a handle on its credit crisis. (Yes, I know, we’ve all heard that one before.)

American investors had more to go on than just hope: They focused on the sharp drop in yields on the companies’ mortgage-backed securities, as investors jumped in to buy the bonds in the open market.

The annualized yield on the benchmark Fannie Mae 30-year mortgage-backed bond tumbled to a five-month low of 5.21% from 5.63% on Friday. A similar security issued by Freddie Mac fell to 5.39% from 5.74%.

Paulson on Sunday announced that the Federal Housing Finance Agency, which regulates Fannie and Freddie, would take control of the companies under a conservatorship. The government justified the move by saying that the companies risked running out of capital because of rising loan losses.

By seizing Fannie and Freddie, Uncle Sam is effectively guaranteeing all of their debts. Investors, who’ve been increasingly worried that the companies could fail, now view their bonds as money-good. And with mortgage-bond yields still well in excess of the 4.27% yield on 30-year U.S. Treasury bonds, there’s a decent premium there for buyers.

If investors demand less on mortgage securities, Fannie and Freddie can demand less in buying or guaranteeing loans from banks and thrifts. If mortgage rates fall, that could bring more buyers into the glutted housing market, while also giving an assist to strapped homeowners who are trying to refinance.

‘This was exactly what [Paulson] wanted to see,’ said Scott Simon, a mortgage bond fund manager at Pimco in Newport Beach. ‘It sends a very strong signal to the market’ about the direction of home loan rates, he said.

The average 30-year mortgage rate as tracked by Freddie Mac had jumped from 5.48% early in January to a recent peak of 6.63% in late July, even as short-term interest rates fell. The loan rate has been easing in recent weeks but still was 6.35% last week.

Of course, there’s no guarantee that lower loan rates will fuel a new home-buying wave. But they certainly can’t hurt -- unless you’re a potential buyer who would like to see prices come down much more than they already have.

For Fannie and Freddie bonds, one key is what happens to foreign investors’ appetite for the securities. Historically, they have been big buyers. And with the dollar on a hot streak, U.S. assets should be more attractive to foreigners.

‘It is likely that foreign investors will step up and buy more agency debt, not less,’ said Tony Crescenzi, bond market strategist at Miller, Tabak & Co. If they don’t, he said, that could suggest a bigger problem: fear abroad that the Treasury has taken on too heavy a burden in shoring up Fannie and Freddie.