Sept. 30 (Bloomberg) -- Fannie Mae, Freddie Mac and the Federal Home Loan Banks are paying down debt at a record pace, creating a supply void in bond markets that may have saved U.S. taxpayers $3.8 billion and corporations $230 million in borrowing costs.

Their obligations, known as agency bonds because they’re implicitly backed by the government, fell below $2.7 trillion from almost $3 trillion in December, data from the companies show. Investors moving out of agency bonds may have pushed down yields on the highest-rated corporate bonds by 0.25 percentage point relative to benchmark rates, said Kevin Giddis, head of fixed-income sales, trading and research at Morgan Keegan Inc.

The decline in borrowing comes after the U.S. seized mortgage financiers Fannie Mae and Freddie Mac in 2008 as the government struggled to prevent a meltdown of the financial system. Now that markets are returning to normal, the shrinkage in supply is benefiting borrowers ranging from the government to companies. Agencies account for 5.6 percent of the U.S. credit market, the least since 1998 and compared with 7.5 percent in 2003, according to the Federal Reserve in Washington, forcing investors to find alternatives.

“Everyone in the market knew the Treasury was having to pay more on its debt because Fannie and Freddie’s debt was competing with it: If those issuances are reduced or eliminated it should save the taxpayers billions,” said Peter Wallison, a former general counsel at the Treasury who is now a fellow at the American Enterprise Institute in Washington. Still, “taxpayers are going to suffer huge losses on bailing out Fannie and Freddie, something in the $200 billion to $400 billion range,” he said.

Trend Reversal

The trend marks a reversal of the decade ended last year, when the debt of Fannie Mae, Freddie Mac and the FHLBs grew an average of $184 billion annually, helping fuel a bubble that drove home prices up by 107 percent between 2000 and mid-2006, according to the S&P/Case-Shiller home-price index.

Since the housing market collapsed in 2007, the Federal Reserve has cut its target interest rate for overnight loans between banks to a range of zero to 0.25 percent from 5.25 percent, and the U.S. has lent, spent or guaranteed $11.6 trillion to bolster financial institutions and fight the longest recession in 70 years, data compiled by Bloomberg show.

Companies rated AAA through AA- issued $92 billion in bonds since March, when investors demanded the highest yields relative to Treasuries to own the securities, according to data compiled by Bloomberg. The figure excludes bonds from financial companies that are backed by the Federal Deposit Insurance Corp.

Trimming Yields

Trimming yields by 0.25 percentage point would save them $230 million a year. A similar decline in the Treasuries market would cut the U.S. government’s interest costs by $3.8 billion annually, based on the $1.517 trillion of debt issued in 2009.

Isolating the effect of the shrinking agency market is complicated because the Fed is buying debt, the economy may be emerging from a recession and investors are converting more cash into bonds as benchmark rates fall, said Giddis, who is based in Memphis, Tennessee.

Fannie Mae, Freddie Mac and the 12 FHLBs are becoming less important to the bond market a decade after they began regularly scheduled debt sales, seizing on the notion that projected U.S. budget surpluses would reduce the supply of Treasuries and make agency securities a pricing benchmark for investors.

The idea gathered steam in 2001, when the U.S. suspended sales of 30-year bonds and the combined stock market value of Washington-based Fannie Mae and Freddie Mac of McLean, Virginia, peaked at $136 billion. Since then, their shares have fallen more than 95 percent.

Changing Mix

“What you’re seeing is a change in the debt mix for investors,” said Greg Peters, head of credit strategy at New York-based Morgan Stanley, the fourth-biggest underwriter of U.S. investment-grade corporate debt as measured by Bloomberg data. “The agency piece was always a rather sizable piece, so the fact that that’s not available means you’re looking at a lot of money flowing into high-grade corporates and Treasuries.”

Now, the U.S. government and companies are the ones stepping up sales of fixed-income securities.

The Obama administration boosted marketable government debt by $1.14 trillion, or 19 percent, this year through August to $6.94 trillion to fight the worst global recession since World War II with stimulus spending. That includes $95.6 billion it pumped into Fannie Mae and Freddie Mac through as much as $400 billion in capital lifelines. Companies and governments issued $965 billion in the U.S. corporate debt market this year, a 10.5 percent increase from the $873 billion for all of 2008, Bloomberg data show.

Interest Costs

Even with the extra supply, yields on 10-year Treasury notes have averaged 3.17 percent this year, down from 3.64 percent in 2008, as investors sought the safety of government debt in the first half of 2009. The U.S. government has spent $367.8 billion in interest expense this fiscal year ending Sept. 30 through August, compared with $451.2 billion for all of fiscal 2008, government data show.

Investor demand for corporate bonds rated AAA through A pushed down yields to 1.89 percentage points more than Treasuries on average, from as high as 5.35 percentage points in March, according to Merrill Lynch & Co. index data.

The Fed is adding to the dearth of available agency bonds by purchasing $200 billion-worth to shore up the housing market.

As supply has fallen, average agency bond yields have dropped to 0.31 percentage point more than Treasuries, from 0.42 percentage point in the decade through last year, Merrill Lynch data show. That gap reached a record 1.71 percentage points in November on speculation the government’s plan to guarantee bank debt would flood the market for U.S.-backed bonds.

‘Big Beneficiary’

Tighter agency yield spreads means top-rated corporate bonds are “a big beneficiary of money moving to look for a higher yield,” said William Quinn, chairman of Fort Worth, Texas-based American Beacon Advisors Inc., which oversees $33 billion in mutual funds.

Dell Inc. sold $1 billion of bonds in June, including $400 million of 3.375 percent three-notes that yielded 1.5 percentage points more than similar-maturity Treasuries. In April, the world’s second-largest maker of personal computers paid a spread of 2.5 percentage points on five-year notes. The offering came just after Fannie Mae decided to forgo a debt sale.

“We’ve been able to very successfully, and I think pretty favorably on a price basis, raise some debt,” Michael Dell, the Round Rock, Texas-based company’s chairman and chief executive officer, said in July.

The $195 million American Beacon Intermediate Bond Fund bought $235,000 of the Dell bonds, helping raise its corporate investments to 38.5 percent of holdings on June 30, from 23.8 percent on Oct. 31. Its agency debt fell to 7.6 percent in July from 11.8 percent in October, regulatory filings and Chicago- based Morningstar Inc. data show.

Central Banks

Foreign central bank investments in agency debt and the separate, growing market for mortgage securities backed by Fannie Mae, Freddie Mac and Ginnie Mae, peaked at $984 billion in July 2008, before falling to $770.6 billion as of Sept. 23, Fed data show. In the same period, their holdings of Treasuries climbed to $2.08 trillion from $1.36 trillion.

The largest “agency buyers themselves are not being forced into the corporate space,” said Jeanmarie Genirs, head of liquid syndicate in New York at Deutsche Bank AG, the fourth- largest underwriter of agency debt as measured by Bloomberg data.

Instead, they’re shifting to securities such as dollar- denominated bonds from Germany and supra-sovereign issuers such as the World Bank, she said. “The overall low-rate environment and lack of alternatives for somewhat greater yields are perhaps making other investors a bit quicker to take on a little more risk.”

Bernanke’s Goal

Reducing the cost of credit relative to what the government pays has been one of Fed Chairman Ben S. Bernanke’s main goals for this year.

Home buyers now pay an average 5.18 percent on 30-year fixed-rate mortgages, according to Bankrate.com in North Palm Beach, Florida. That’s down from 6.46 percent in October 2008. The mortgages cost 1.88 percentage points more than yields on 10-year Treasuries, compared with 3.27 points in December, Bloomberg data show. The average gap for the five years ending with 2007 was 1.53 points.

Fannie Mae and the FHLBs were created to revive home lending in the Great Depression, as part of President Franklin D. Roosevelt’s New Deal programs.

In 1968, with Vietnam War costs straining the federal budget, Fannie Mae was split from the government. The company retained its access to a credit line provided by the Treasury and state-tax exemptions, links that implied government backing and allowed it to borrow more cheaply than other companies.

Expanding Investments

Freddie Mac was created in 1970 to foster competition. Initially owned by the Federal Home Loan Banks, it went public in 1989.

To boost profits, Fannie Mae and Freddie Mac increased their investments in mortgage bonds even as critics such as Alan Greenspan, Fed chairman from 1987 to 2006, complained that the holdings increased risks ultimately borne by taxpayers. Fannie Mae’s investment portfolio grew by more than 10 percent in the dozen years through 2004. Freddie Mac’s climbed each year from 1987 through 2005. Today, their combined holdings total $1.6 trillion, up from $108.1 billion in 1985.

Fannie Mae and Freddie Mac avoided stricter portfolio rules until disclosures in 2003 and 2004 that they misstated earnings. Former Fannie Mae CEO Franklin Raines was accused by regulators in a 2006 civil suit of overstating profits by $6.3 billion to boost bonuses; Raines last year agreed to $24.7 million in penalties without admitting wrongdoing.

Housing Collapse

The companies sank as the housing market collapsed in 2007, sparking a combined $165.3 billion of losses in the past two years. The Treasury took control of both on September 7, 2008, providing each with lifelines that now total $200 billion.

A week later, Lehman Brothers Holdings Inc. filed for the biggest bankruptcy in U.S. history, Merrill Lynch & Co. was forced to sell itself to Charlotte, North Carolina-based Bank of America Corp. and the U.S. agreed to bail out insurer American International Group Inc. of New York.

This year, Fannie Mae and Freddie Mac haven’t had to borrow as much because they are keeping investment holdings below government-imposed caps of $900 billion and as Fed purchases of $1.25 trillion of mortgage bonds limit their ability to make profitable trades.

Both ended August more than $100 billion below the cap. Starting in 2010, the companies will be required to reduce their investments by 10 percent annually to $250 billion each.

Biggest Decline

The U.S. hasn’t said how long the companies will remain in government hands or how they will emerge. Most proposals assessed in a General Accountability Office report this month call for the elimination all or most of their holdings, which may further reduce their debt needs.

Borrowing by Federal Home Loan Banks, the dozen regional government-chartered cooperatives owned by more than 8,000 members from New York-based JPMorgan Chase & Co. to Bank of Beaver City in Oklahoma, is down the most.

The FHLBs, which sell bonds to fund loans to members, cut obligations to $1.04 trillion in August from $1.33 trillion in November 2008, as banks limited lending and found alternative sources of cash, including deposits and proceeds from the sale of bonds backed by the FDIC.

Agriculture Businesses

When including the Federal Farm Credit Banks, government- chartered cooperatives for agriculture businesses, the agency debt market may fall to $2.5 trillion by mid-2011 from $3.3 trillion in October, said Nancy Vanden Houten, an analyst at Stone & McCarthy Research Associates in Skillman, New Jersey. The amount outstanding was about $1.6 trillion in 2000.

“Issuance up until now has been massive and the amount outstanding is huge,” said Chris Sullivan, who has about 20 percent of the $1.5 billion he oversees as chief investment officer at United Nations Federal Credit Union in New York in agency debt. For U.S. financial companies and central banks thatbuy the securities, “the next best substitute” may be the Treasury market, where “we have explosive issuance,” Sullivan said.

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

Last Updated: September 30, 2009 00:01 EDT