Dec. 5 (Bloomberg) -- The Federal Reserve bought $5 billion of Fannie Mae, Freddie Mac and Federal Home Loan Bank corporate debt under a new program aimed at reducing mortgage costs.

The central bank acquired bonds with maturities between December 2009 and November 2010, according to the New York Fed’s Web site. Dealers offered $12.9 billion of the securities. The purchases under the $100 billion program are the Fed’s first buying of long-term “agency” debt in 28 years.

Asset buying by the Fed represents “step three” in the U.S. government’s efforts to fix the financial system and curb a yearlong recession, following provisions of loans and capital to banks, George Goncalves, the chief Treasury and agency strategist with Morgan Stanley, wrote in a note to clients today.

“Moving to actually purchasing assets and not just funding them -- this as we have been saying is the quantum leap that will work off the liquidity programs in place,” Goncalves said. New York-based Morgan Stanley is one of 17 primary dealers that trade with the central bank.

Fed Chairman Ben S. Bernanke finds it “encouraging” that his plan announced last week to buy $100 billion of so-called agency debt and $500 billion of agency mortgage bonds has already spurred a drop in loan rates, he said Dec. 1. The government has sought lower rates as a way to stabilize the housing market.

Fed purchases of agency securities and possibly also long- term Treasuries may “influence the yield on these securities, thus helping to spur aggregate demand,” Bernanke said in a speech in Austin, Texas.

Mortgage Rates

The average rate on a 30-year fixed-rate loan dropped to 5.47 percent last week, the lowest level since June 2005, from 5.99 percent the prior week, according to a Mortgage Bankers Association survey released Dec. 3.

Treasury Secretary Henry Paulson is considering using purchases of home-loan securities to force loan rates as low as 4.5 percent, a government official said on condition of anonymity this week. His department in September began buying agency mortgage bonds, though not agency corporate debt; the Fed in September bought agency debt maturing in less than one year amid a run on money-market funds.

Agency debt is primarily the borrowings of government- sponsored enterprises including Fannie, Freddie and the home loan banks, as well as U.S. agencies including the Tennessee Valley Authority and Ginnie Mae. The debt carries either an implied or explicit government backing that typically allows the institutions to borrow at lower yields relative to other bonds.

Philosophical Shift

Bernanke’s steering of the Fed into long-term agency debt and mortgage securities follows a retreat by foreign central banks. Those holdings have shrunk by about $116 billion from a July record to $868 billion amid concern that the U.S. support for Fannie and Freddie may not be durable enough and because of sales to support weakening currencies, according to Fed data.

The only previous period in which the Fed bought agency debt was between September 1971 and April 1980 amid pressure from Congress that ended after the election of President Ronald Reagan ushered in a “philosophical shift in the role of government,” according to Skillman, New Jersey-based Stone & McCarthy Research Associates. The Fed, which also accepts agency debt as collateral for loans and in operations to temporarily drain liquidity from financial markets, remained an owner through 2003.

The Fed has yet to detail its plans to buy mortgage bonds guaranteed by Fannie or Freddie, which were seized by the government on Sept. 6. Their higher borrowing costs have hindered their ability to increase their $1.5 trillion mortgage portfolios. The program, which would also buy Ginnie Mae mortgage debt, is aimed to start this month.

Yield Spreads

The difference between yields on Fannie’s two-year corporate debt and two-year U.S. Treasuries fell 0.07 percentage point to 1.16 percentage points as of 3:50 p.m. in New York, according to data complied by Bloomberg. The spread is down from a record 1.82 percentage points on Nov. 20.

U.S. agency debt, which has returned less than government notes in six of the past seven months, is outperforming Treasuries by 0.34 percentage point this month through yesterday, according to Barclays Capital index data.

The New York Fed’s Web site says that the agency-debt purchases are being “financed through the creation of additional bank reserves,” meaning the central bank is adding money to the financial system with the buying.

“In the initial phases of the rescue effort, the Fed sterilized all its operations, by offsetting its purchases by selling something else,” Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey, said.

Inflation Risk

The shift after Lehman Brothers Holdings Inc.’s September collapse may stoke inflation, though that depends on banks using the money being pumped into the system to lend and invest and that may not occur, Crandall said in a telephone interview today. It also “remains unclear whether they’re going to look for new tools in 2009 to eventually try to offset some of this,” he added.

The initial agency-debt purchases represent a “drop in the bucket” in relation to other sources of the growth in the Fed’s balance sheet, “especially the currency arrangements with foreign central banks,” Crandall said, though when combined later buying and mortgage-bond purchases may be significant.

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

Last Updated: December 5, 2008 16:12 EST