Mortgage-market revival: Try, try again
The feds are trying to stimulate housing activity, but two earlier efforts show success won't come easy.
NEW YORK (Fortune) -- The feds are trying once more to resuscitate the mortgage market. But history shows reviving this patient won't be easy.
The Federal Reserve said Tuesday morning it would spend $600 billion in coming quarters to buy the bonds and mortgage-backed securities issued or guaranteed by Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500). The move, the Fed said, aims "to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally."
The market reacted positively to the announcement, with the spreads between the yields on agency bonds and similar-duration Treasury securities narrowing. Lower spreads translate to lower mortgage rates, which bring down the cost of buying houses. That generally leads to more house sales - a top priority for officials who want to slow the decline in house prices that is soaking financial-sector balance sheets with losses.
The decision to buy agency debt and mortgage-backed securities shows policymakers are "looking to drive mortgage rates down," says Bill Larkin, a fixed-income portfolio manager at investment adviser Cabot Money Management in Salem, Mass. "They need to get them close to 5% if they want to get the housing markets going again."
That will take some doing, though. The rate on a 30-year fixed mortgage was around 6% Monday, before rates fell Tuesday on word of the Fed plan. The lowest rate on record since the St. Louis Fed started tracking conventional 30-year mortgage rates was the 5.23% reached in June 2003, in the midst of the housing bubble that inflated earlier this decade.
Larkin says the government will need to bring the rate down into that range to create demand for mortgage refinancing, and to get current homeowners who'd like more room or a better location to think about making a change. Larkin notes that homeowners who took advantage of the last refinancing opportunity in January, when rates on a 30-year fixed mortgage dropped briefly to around 5.5%, won't be tempted to refinance again - thereby incurring additional fees and in many cases having their houses assessed at lower values - till rates go substantially lower.
Still, government officials clearly view reducing mortgage rates and bolstering house sales and refinancing activity as one of their few good options in the midst of financial sector meltdown. Treasury Secretary Henry Paulson has tried at least twice this year to bring down mortgage rates, by seeking to ease market fears about the health of the main conduits for U.S. mortgage financing, Fannie Mae and Freddie Mac.
In July, as mortgage rates soared, Paulson announced a plan for the government to provide backup financing for the companies, whose publicly traded shares had come under attack amid questions about the adequacy of their capital. That move initially brought mortgage rates down and narrowed the spread between agency bonds and Treasurys, but the 30-year mortgage rate remained stubbornly above 6%.
In September, Paulson put the companies into conservatorship, citing a need to clarify the companies' role in the economy and their relationship to the government. "Fannie Mae and Freddie Mac are so large and so interwoven in our financial system," he said Sept. 7, "that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe."
That move - which was accompanied by the announcement of a federal plan to buy mortgage-backed securities similar to today's announcement - led to a deeper decline in mortgage rates than had July's move. The 30-year fixed rate tracked by the St. Louis Fed fell to 5.78% on Sept. 18 from 6.35% the week before the nationalization.
But the collapse of Lehman Brothers, the near implosion of AIG and the plunge of world stock markets this fall resulted in a new flight to the liquidity of Treasury bonds that widened agency spreads and pushed mortgage rates back up over 6%, where they have largely been since then.
That's partly because the government hasn't been able to devote much firepower to buying mortgages, what with the crisis-a-day schedule of recent months. And it's partly because the investors who once were avid buyers of agency bonds have fled for the greater safety and liquidity of Treasury bonds.
Brad Setser, an economist at the Council of Foreign Relations, says that in the third quarter, China bought $81 billion of Treasurys and sold $16 billion of agencies. Just a quarter earlier, China was buying more agencies than Treasurys, Setser writes at his blog. Larkin says questions about the liquidity in the markets for agency bonds continue to push investors toward Treasurys, which give holders the security of knowing they can sell without a hitch at any moment.
One other question mark comes from this week's debut of the Federal Deposit Insurance Corp. corporate-bond loan-guarantee program. Goldman Sachs (GS, Fortune 500) issued $5 billion worth of bonds Tuesday under the plan. Larkin calls those bonds "interesting," and says he believes the FDIC label could emerge as the new mark of quality in the bond market, what with the ratings issued by agencies like S&P and Moody's largely discredited.
But if the FDIC plan works and issuers like Goldman and Morgan Stanley (MS, Fortune 500) come quickly to market with billions of dollars in new issues, it could draw some investor demand away from the agencies, counteracting some of the gains from federal purchases of Fannie and Freddie securities.
And Edward Gainor, a lawyer at McKee Nelson in Washington, notes that the Fed approach to the mortgage-backed securities market neglects the most troubled part of that market - the one for bonds not backed by Fannie and Freddie, some of which continue to weigh on financial institutions' balance sheets.
"The non-agency MBS market is not functioning," he says, "and no program has yet been announced that will stimulate that market." 
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