Mortgage rates drop; investors applaud Freddie, Fannie rescue

— -- Wall Street staged its biggest rally in a month Monday as stock investors bet that the government's move to seize and backstop the USA's two largest mortgage finance companies will help stabilize the housing market, thaw credit markets and boost the ailing economy.

The Dow Jones industrial average jumped 289.78 points, or 2.6%, to 11,510.74. But common shares of Fannie and Freddie were essentially wiped out, since common-stock shareholders are last in line in any claims.

The jubilant response to the historic federal takeover of Fannie Mae and Freddie Mac was driven by a belief among investors that a financial panic can be averted. Investors had feared that home buyers wouldn't be able to get credit if the two institutions folded.

Still, investment pros caution that the intervention won't cure the crisis in the housing and mortgage markets or lead to any immediate economic recovery.

"It takes one of the major issues off the table: the uncertainty of what would happen if these two entities failed" under the weight of a tsunami of unpaid mortgages, says Chuck Carlson, a portfolio manager and contributing editor of Dow Theory Forecasts.

Michelle Clayman, chief investment officer at New Amsterdam Partners, says the rescue "calmed fears" and sent a message to investors, homeowners and potential home buyers that cash to fund real estate purchases and transactions would not dry up.

But, she adds, "There's still some worrying data out there. Home inventories remain high. Foreclosure data is high, with 9% of all mortgages delinquent. That's huge. And you will continue to see financial institutions in distress. Is this an all-clear signal? Not necessarily."

The housing market has been suffering from falling prices, a record spike in foreclosures and a weak economy. The government's plan to inject up to $100 billion in each of the two government-sponsored entities has already helped lower mortgage rates, reducing costs for borrowers.

It's anyone's guess whether Monday's gains in the stock market will stick. Stocks rallied furiously on two other recent occasions when the government stepped in to avert a meltdown in the current financial crisis: In mid-March, when it orchestrated JPMorgan's purchase of Bear Stearns, and in mid-July, when it first announced plans to prop up Fannie and Freddie if necessary.

Both rallies stalled, and stocks fell to their prior levels within a week. Scott Black, president of Delphi Management, says this rally may also be fleeting. One big problem, Black says, is that there's no quick cure to the oversupply of homes for sale.

The government's decision to take over the two publicly traded companies generated some skepticism in Washington. Senate Banking Committee Chairman Chris Dodd, D-Conn., said he wasn't necessarily opposed to the move but needed to know a lot more detail and plans to hold a hearing later this week.

Peter Schiff, president of Euro Pacific Capital, argued that the government's intervention will actually prolong the housing downturn. The plan, he says, is designed to keep home prices from falling. And that means prices will remain artificially high, setting up the government-controlled lenders for a wave of fresh foreclosures in the future.

"It will make the problem bigger," Schiff says.

Others agree that beyond Monday's celebratory bounce on Wall Street, it's far from clear that the government's move will solve other problems related to the housing crisis.

Here's a look at some possible consequences:

Mortgage rates

Average rates on 30-year fixed-rate mortgages, which have hovered well above 6% for months, plunged from 6.5% Friday to near 6% Monday, says Bankrate.com, according to national overnight averages. And most analysts expect the government's takeover of Fannie and Freddie to extend that decline, at least in the short term.

In part, that's because in taking control of the two companies, the U.S. Treasury will buy mortgage-backed securities, thereby driving their prices up and mortgage yields down. The takeover should also shore up confidence in Fannie and Freddie and the mortgages they own or guarantee.

"Early indications are that mortgage rates are dropping about half of a percentage point," says Greg McBride, senior financial analyst at Bankrate.com. "It remains to be seen if this will hold, because investors are bound to be concerned about how much debt Uncle Sam is taking on."

As of Friday, mortgage rates were a full percentage point higher than they would be expected to be based on the benchmark 10-year Treasury yield, he says, noting that the spread between the two rates was the widest it had been in 22 years.

"That spread will improve as a result of the takeover by the government," McBride says. "But the spread will not immediately go back to the historical average, because there is still a lot of uncertainty about the quality of outstanding mortgages."

With Fannie Mae and Freddie Mac having placed their primary focus on merely surviving, McBride says, they were buying fewer loans and charging higher fees on the loans they did buy, resulting in higher rates for borrowers.

"Short term, this is a definite win for borrowers," he says. "The availability of mortgage credit is not in question. Borrowers will see better terms."

Cameron Findlay, LendingTree chief economist, says borrowers will see better rates, but maybe not as attractive as they'd hoped. He cautions that lenders might not pass all the benefits on to borrowers.

By Anna Bahney

Home affordability

The takeover could provide relief to the housing industry and ultimately help lower-income home buyers. But, in the short term, it will not aid homeowners behind on their mortgages or those who owe more than their homes are worth. Still, it is expected to help low- and moderate-income buyers in search of affordable homes — part of the companies' founding missions.

"Theoretically, it should open the markets back up for lower- and moderate-income buyers," says David Grunwald, president of American Sunrise Communities, a Los Angeles-based organization that helps families with affordable housing and foreclosure issues. Many lower-income families looking to buy homes were squeezed out of the market because they were unable to get loans because of tighter lending standards and a general lack of liquidity in the market. The takeover is expected to lower mortgage rates and make mortgage credit more widely available. That should allow more loans for creditworthy low- and moderate-income home buyers who meet current underwriting standards.

Some critics of Fannie Mae and Freddie Mac in Congress and elsewhere have complained in recent years that the companies have been coming up short on affordable housing goals that go along with their federal charters.

"The federal government stepping in should have a positive impact on low- and moderate-income buyers, because it will free up capital for those mortgages," says Grunwald.

Housing legislation enacted in July includes provisions for government-backed refinancing for troubled borrowers who can get lenders to reduce what's owed on the house. The same legislation authorized the new conservatorship of Fannie Mae and Freddie Mac, the government action Sunday.

But the move offers no relief to distressed borrowers, says Brandon Green, a real estate broker in Washington, D.C.: "This isn't going to do anything for homeowners now in trouble."

By Stephanie Armour

Bond market

Interest rates for the most creditworthy borrowers should fall as a result of the Treasury's intervention. But if the takeover of Fannie and Freddie becomes costlier than current estimates, the Treasury will have to borrow more money. And that could push rates higher.

The government's bailout of Freddie and Fannie does little to help struggling corporate borrowers. In fact, yields on high-yield corporate debt, or junk bonds, rose modestly on news of the bailout.

Why? Because the government's rescue of the mortgage giants revealed that the economy was in worse shape than many people realized.

"In our view, the economy is probably in a recession, and it's likely to get worse," says Van Hoisington, manager of the Wasatch-Hoisington U.S. Treasury Fund. In a poor economy, the risk of default by shaky borrowers rises, and investors demand higher yields to compensate them for that risk.

Risk-averse investors rushed to safe U.S. Treasury bonds Monday, tugging the yield of the bellwether 10-year Treasury note to 3.68% from 3.69% Friday. Treasury securities, which are backed by the U.S. government, are considered free from default risk.

The government pledged that bonds issued by Freddie and Fannie would continue to pay interest, and that reassured investors in other government agency bonds, such as those issued by the Federal Home Loan Banks.

In the long run, though, the Treasury might have to issue more debt to cover the cost of the bailout, and that could push Treasury rates higher, says Robert Gahagan, senior portfolio manager for American Century. Now, however, the increase in Treasury borrowing to cover Fannie and Freddie is negligible, Hoisington says.

If the economy slumps, bond fund investors should see lower yields and higher share prices. But if rates rise in the long term, bond investors' total returns would fall.

By John Waggoner

Financial sector

Investors hope the rescue plan for Fannie and Freddie may also throw a life preserver to the financial sector. Shares of financial-company stocks, which have been sinking for more than a year, jumped Monday as uncertainty surrounding the mortgage giants lifted.

Ideally, the government's plan to deal with Fannie and Freddie will help lower mortgage rates, slow the fall in home prices and prevent more loans owned by banks and other financial services firms from going sour. All that could boost financial companies and their stocks, which account for roughly 15% of the value of the stock market.

"If this stabilizes the housing market, you can connect the dots to the financials," says Quincy Krosby, chief investment strategist at The Hartford. "It removes uncertainty weighing on the market."

The financial Select Sector SPDR exchange traded fund, which tracks banks and brokerage stocks, soared 4.3% Monday, and the KBW Bank index, which mirrors bank stocks only, jumped 6.9%.

What the financial industry and financial stocks need most is for home prices to stop dropping, says Rod Smyth of Riverfront Investment Group. The government's move might not stop prices from falling an additional 10% to 15%, he says, but it does reduce the likelihood of a steeper slump, he says.

The banks may benefit as many of the loans they own are sold or priced into a government-backed market, says Lana Chan, analyst at BMO Capital. Chan cautions, though, that the federal intervention doesn't fix the underlying troubles banks face, including slower economic growth.

"I don't see how this helps," says Chip Hanlon of Delta Global Advisors, noting that moves made so far to ease the crisis haven't erased the financial sector's woes. But Smyth notes that the Treasury's action could make it easier for banks to recover and could boost investor confidence. Still, he says, "Home prices are where all this begins and ends."

By Matt Krantz

Preferred stock

The Treasury Department move is hitting banks and thrifts that hold Fannie Mae and Freddie Mac stock. The plan dilutes the value of the existing $36 billion of the firms' preferred stock, while ending crucial dividend payments.

In a sign of potential problems, Sovereign Bancorp, which had $622.6 million of the firms' preferred stock as of June 30, saw its own stock plunge about 7% on Monday. Sovereign made a required federal filing warning investors of an unexpected financial hit. Wells Fargo made a similar filing.

Cam Fine, CEO of the Independent Community Bankers of America, says 5% to 8% of the group's more than 5,000 member institutions hold some Fannie Mae or Freddie Mac stock. About 20 could see a material impact as the stock declines. Some offerings of Fannie Mae preferred stock lost three-fourths of their value in Monday trading.

Federal bank regulators Sunday said a "limited number of smaller institutions" have Fannie Mae and Freddie Mac holdings that are significant compared with their capital. They pledged to work with lenders on plans to replenish capital, if needed.

Bob Davis, an American Bankers Association executive, said regulators have yet to spell out what that help could entail, though he would expect some latitude given the unexpected federal action.

Lenders told Fine that bank examiners were calling individual institutions Monday to determine if they hold stock or securities. Some bankers worry regulators will cast a critical eye on other areas, such as stock issued by the 12 Federal Home Loan Banks. Federal Housing Finance Agency Director James Lockhart said Sunday all but one of the 12 banks are profitable. The banks will have access to a new Treasury lending facility, but Lockhart doesn't think they'll need to use it.

"The local community banks, if they get nervous … could have an impact on our economy," Fine says.

If the Treasury plan bolsters the housing market, banks will benefit. Still, "Regulators are going to have to say, 'We understand that you got blindsided,' " says Brian Bethune of Global Insight.

By Sue Kirchhoff