Nov. 3 (Bloomberg) -- Foreign central banks and sovereign investment funds will halve their net purchases of U.S. agency mortgage securities as falling U.S. trade deficits and oil prices cut into reserves, according to Bank of America Corp.

The overseas investors' portfolios of Fannie Mae, Freddie Mac and Ginnie Mae mortgage bonds will climb by $30 billion to $40 billion annually in coming years, down from an average of $71 billion a year from 2004 through 2007, Bank of America said in an Oct. 31 report.

The report underscores the macro-economic challenges faced by Treasury Secretary Henry Paulson in his bid to narrow the difference between yields on agency mortgage bonds and benchmarks and bring down mortgage rates to ease the housing crisis. Foreign investors ``have been absorbing a significant portion'' of the growth in the almost $5 trillion market, New York-based strategists including Sharad Chaudhary and Ohmsatya Ravi wrote.

``Any change in their purchase patterns could have a meaningful impact on spreads,'' the strategists wrote.

In recent weeks, foreign institutions have engaged in ``significant selling'' in the $3 trillion market for Fannie, Freddie and Federal Home Loan Bank corporate debt to raise money to ``defend their currencies,'' the report said. It didn't forecast demand for agency debt, only agency mortgage securities, or specify the countries that are buying their own currencies.

Conservatorship

Paulson put Fannie and Freddie into a government-run conservatorship over the weekend of Sept. 7 to reassure buyers of their debt and mortgage securities, and prevent the companies from being forced to shrink amid capital-depleting losses. He directed the firms to grow and began having his department buy their mortgage bonds to help lower the cost of home financing.

Spreads between Washington-based Fannie's current-coupon, 30-year fixed-rate mortgage bonds and 10-year Treasuries today fell about 2 basis points to 205 basis points as of 10:30 a.m. in New York, data compiled by Bloomberg show. A basis point is 0.01 percentage point.

The spread reached a seven-month high of 221 basis points on Oct. 28, near the 22-year high of 238 basis points set in March. The average rate on a typical U.S. fixed-rate mortgage last week touched 6.46 percent, the highest since Aug. 7 and only 4 basis points short of a six-year high, according to Bankrate.com data.

Foreign central-bank holdings of agency debt and agency mortgage bonds dropped by a monthly record of $55.4 billion over the five weeks ended Oct. 29 to $915 billion, Federal Reserve data show. That compares with a record $983.9 billion on July 16. Demand for the agency debt may remain weak among central banks as investors consider buying competing new bank debt with government guarantees, the Bank of America report said.

Source of Pressure

A jump in agency debt spreads has been a ``major source of pressure'' for agency mortgage-bond spreads, according to an Oct. 31 report from JPMorgan Chase & Co. Higher borrowing costs for Fannie and Freddie may it harder for the companies to profitably buy mortgage bonds and also offer bond buyers higher yields on other potential investments.

The U.S. trade deficit shrank 3.5 percent to $59.1 billion in August as a retreat in oil prices cut the import bill, Commerce Department data show. The deficit, which hit a record of $67.1 billion in October 2005, will be lower by about $15 billion a month next year, according to Bank of America's report.

The deficit will fall to 4.4 percent of the U.S. gross domestic product next year, down from 4.9 percent this year and 5.3 percent in 2007, according to the median forecast of 43 economists surveyed by Bloomberg. Crude oil through last week has fallen 53 percent from its record $147.27 a barrel on July 11.

Overseas Demand

Foreign central banks and wealth funds have accounted for 78 percent of overseas demand for agency debt and mortgage securities since 2004, according to the Bank of America strategists' estimates based on Treasury data.

About 75 percent of the $236 billion of agency mortgage securities held by official overseas investors are owned by institutions in China, with most of the rest held by Taiwan, South Korea, Singapore, Malaysia and the United Arab Emirates, according to their report. Official institutions own about 41 percent of the total held overseas.

China, Russia and Japan own about 55 percent of all agency debt held by official investors, with South Korea, Australia, Mexico, Taiwan, Malaysia and the United Arab Emirates owning most of the rest, the report said. Official institutions own about 70 percent of the total held overseas.

Currencies of developing countries tumbled in October on concern the global economic slump will sap demand for emerging- market assets. Russia's ruble weakened 5.2 percent to 27.07 per dollar, the largest drop since 1999, one year after it defaulted on $40 billion of sovereign debt. Mexico's peso lost 14.7 percent to 12.8259 per dollar, the most since 1994, when Mexico abandoned its peg to the dollar and devalued the currency.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.

Last Updated: November 3, 2008 12:45 EST