Federal Reserve & Interest Rates

With the government finally seizing control of Fannie Mae and Freddie Mac, it finally put’s to rest the dark cloud hanging over the entire mortgage market.  Equity holders were the big losers over the weekend with bond holders coming out as the big winners.

Bond holders now know that Fannie and Freddie’s debt has the full backing of the U.S. government behind it, which pretty much put’s them on par with Treasury Securities for credit rating.  The spreads between the two which had been at their highest in years were a major cause in mortgage rates being as high as they were.

We should see a shrinking of the spread in the upcoming weeks.  The most likely occurrence is that Fannie and Freddie bonds will rally, causing yields to fall but at the same time, some of that money could come out of Treasuries, with a selloff causing yields to rise.

While a rise in Treasury yields would not necessarily be a good thing, it is hoped that the housing market will eventually benefit from the takeover and alleviate some of the pressure on credit markets.  The big thing will be how mortgage rates will react.

With the full backing of the U.S. government now behind them, it will be interesting to see if Fannie and Freddie will increase there purchases of mortgages in the near future.  That more than anything will go a long way in helping banks increase the pace of their lending.

Even with the takeover, the two agencies will still have to raise a significant amount of capital if they are to help out the sagging housing market anytime soon.  They will need to sell a lot of debt and how much spreads shrink will determine how expensive that could be.

The government will likely have to increase their exposure to loss in order to stimulate mortgage markets.  No one knows what the eventual cost to taxpayers will be but the sooner the housing market recovers the cheaper it will be for all of us.

Investors are demanding an increasingly higher premium over Treasury yields as spreads on investment grade bonds have widened recently.  If spreads stay this wide, it will be more expensive for many corporate and government entities to raise capital through bond issues.

The gap climbed 3 basis points to a record 311 basis points today, according to Merrill Lynch & Co.’s U.S. Corporate Master index. It was the third time the spread reached a new high this week, surpassing the gap of 305 basis points set March 20, just after the government brokered a takeover of Bear Stearns Cos.

During the current credit crisis financial firms have scrambled to raise hundreds of billions of dollars in capital to cope with the half a trillion in writedowns they’ve taken since last fall.  The continuing weakness in credit and housing markets have many investors predicting that the Fed will keep interest rates at 2% at least until the end of the year.

You have some analysts saying the housing slump could continue well into 2010 if not longer.  Home prices are expected to fall another 15%-20% before it’s all said and done.

Right now the problems in both sectors are feeding off each other.  Defaults and foreclosures are causing more writedowns, while weak credit conditions have caused mortgage rates to rise and is making it difficult for prospective home buyers to enter the market.

Just last week American Express issued 5-year notes at close to junk bond levels despite it’s relatively high credit rating.  You’re seeing spreads rise this high because realistically no one know how close we are to the actual bottom.

The settlement brokered by New York Attorney General Andrew Cuomo with investment banks to buyback billions in auction rate securities will only help a fraction of the investors that bought into the trouble market.

The deals so far announced total about $56 billion of the auction-rate securities market — but there are $210 billion of such securities unredeemed, according to research firm Restricted Stock Partners.

Basically unless you were a client of one the brokers running the auctions you could be out of luck.  Investors that bought from discount brokerages could be stuck holding the bag, since their brokers had no knowledge of the breakdown in the auction rate market and for the most part have not been considered liable.

The investment banks that underwrite the actual auctions are only agreeing to take care of their own clients and even then there are still some gray areas.  Short of legal action it will be unlikely the majority of investors will see any of their money anytime soon.

With investment banks desperate for capital they will probably fight tooth and nail to buyback as little as possible.  However, these investments aren’t really in danger of failing, as much of it is made up of relatively safe municipal bonds.

The sticking point and the crux of the government’s argument with investment banks is that auction rate securities are in actuality long term investments but they were marketed as “like cash”.  Interest rates reset on the securities usually every 7 or 28 days so that investors were able to quickly get into and out of the market until auctions started to fail back in February.