Sept. 8 (Bloomberg) -- Mortgage bonds guaranteed by Fannie Mae and Freddie Mac rallied, potentially reducing home-loan rates, after the U.S. government seized control of the companies and vowed to shore up demand.

The difference between yields on Fannie's current-coupon 30- year fixed-rate securities and 10-year Treasuries narrowed 39 basis points to 154 basis points as of 5:01 p.m. in New York, touching the lowest level since February, data compiled by Bloomberg show. The spread reached 216 basis points on Aug. 18, the widest since a 22-year high of 238 set in March.

Treasury Secretary Henry Paulson yesterday threw the AAA backing of the U.S. behind the debt and said Fannie and Freddie will increase their holdings of mortgage-backed securities. The government will also begin buying the bonds starting this month, Paulson said at a news conference in Washington.

``The plan that entails Treasury purchasing MBS resolves the biggest question hanging over the mortgage market,'' Kenneth Hackel, managing director of fixed-income strategy at RBS Greenwich Capital Markets in Greenwich, Connecticut, said in a note to clients. ``Who will be the marginal buyer of MBS going forward? Uncle Sam!''

Losses at Fannie and Freddie have roiled the $4.5 trillion market for mortgage bonds guaranteed by the companies or U.S. agency Ginnie Mae, pushing yields higher against benchmarks. That in turn boosted home loan interest rates just as housing prices staged their biggest decline on record. Paulson is seeking to buttress investor confidence and alleviate the worst housing slump since the Great Depression.

Non-Agency Bonds

The weekend announcements had no immediate effect on the prices of ``non-agency'' mortgage bonds lacking guarantees from Fannie, Freddie or Ginnie, though support for the companies was ``one of things that needed to happen'' to stem surging foreclosures, said Scott Eichel, co-head of asset-backed and mortgage trading at RBS.

The difference between yields on Fannie's securities and 10- year U.S. Treasuries reached as low as 152 basis points in May, and averaged 114 basis points in the five years ended Dec. 31, according to data compiled by Bloomberg. A basis point is 0.01 percentage point. The debt rallied 30 basis points on March 17, the previous biggest single-day drop in at least 10 years, after the Federal Reserve began offering loans to securities firms and facilitated JPMorgan Chase & Co.'s purchase of the collapsing Bear Stearns Cos. by assuming $29 billion of assets.

Further Narrowing

``We haven't seen a day with price action like this in my memory,'' said Scott Kirby, who manages more than $20 billion of structured-finance securities at Ameriprise Financial Inc.'s RiverSource Investments LLC in Minneapolis.

The spread may narrow a further 50 basis points ``over the next few months,'' Bill Gross, who manages the world's largest bond fund at Pacific Investment Management Co. in Newport Beach, California, said in a Bloomberg Television interview today.

Pimco Total Return Fund had about 61 percent of its holdings in mortgage-backed securities on June 30, mostly debt guaranteed by Fannie, Freddie or government agency Ginnie Mae, according to data on Pimco's Web site.

Spreads on other types of debt, such as investment-grade corporate bonds, may fall to a lesser degree as lower yields on agency mortgage securities push investors to allocate more money to other sectors, Andrew Harding, chief investment officer of Allegiant Asset Management in Cleveland, said in an interview.

Requests to Renegotiate

Home lenders should brace for a surge in applications or requests to renegotiate set rates, David Stevens, a former head of Freddie's single-family mortgage business, said yesterday.

``The government intervention will mean that investors will have renewed confidence in agency MBS which will drive rates down,'' said Stevens, who now runs lenders affiliated with Fairfax, Virginia-based Long & Foster Real Estate Inc.

The average rate on typical 30-year fixed-rate mortgages ended last week at 6.08 percent and reached a six-year high of 6.51 percent on July 23, according to Bankrate.com data. The rate reached as low as 5.25 percent on Jan. 23 after the Federal Reserve cut its target rates for overnight loans between banks.

By packaging loans into Fannie and Freddie mortgage securities and selling them to investors such as mutual funds, lenders receive cash to make new loans. The yields that investors are willing to accept help determine the rates lenders need to charge borrowers to make the bond sales profitable.

Net Losses

Freddie's mortgage holdings totaled $798 billion at the end of July, while Fannie's were $758 billion. The companies were set up to buy and guarantee mortgage debt and provide demand that underpins the market. As losses at the world's largest banks and securities firms ballooned to more than $500 billion, prompting them to sell assets, Fannie and Freddie became even more crucial. Concern that sales of mortgage securities may increase sent spreads wider.

The companies recorded a combined $14.9 billion in net losses in the past four quarters, eating into their capital. Fannie and Freddie said last month they may limit purchases to preserve capital and Freddie said it may even be forced to shrink its portfolio.

While the portfolios will increase ``modestly,'' they won't be permitted to exceed $850 billion after 2009 and will then decline by 10 percent each year until they reach $250 billion, the Treasury said. The department said it will begin its own purchases ``later this month'' of new mortgage securities guaranteed by government-sponsored enterprises. September purchases will total $5 billion, government officials told reporters yesterday.

Treasury Purchases

The Treasury's purchases may total $25 billion to $50 billion through 2009, compared with about $30 billion of expected monthly growth in the outstanding amount, according to Vikas Shilpiekandula, a mortgage-bond analyst at New York-based Lehman Brothers Holdings Inc. The benefit will be in the Treasury acting as a ``backstop'' if spreads get too wide, he said on a conference call for investors yesterday.

Concern that forced sales of assets will continue have also driven yield spreads wider on Ginnie Mae securities, which already carried the backing of the U.S. government and influence rates on government-insured mortgages.

The spread on the federal agency's securities to 10-year Treasuries fell 36 basis points to 137 basis points today, compared with an average 101 basis points in the five years ended Dec. 31, according to Bloomberg data.

Rate Concern

Paulson's efforts to lower mortgage rates may be undermined if benchmark Treasury rates rise, said Doug Dachille, chief executive officer of First Principles Capital Management in New York, which oversees $7 billion in fixed-income investments. The government is taking responsibility for $5.4 trillion of debt and mortgage securities, placing them beside Treasuries as some of the safest investments. That may cause government-bond yields to rise, he said yesterday.

``It could be all that happens is Treasuries sell off and mortgages don't move,'' Dachille said.

The yield on Fannie's current-coupon securities fell to 5.05 percent, from 5.63 percent last week, according to data complied by Bloomberg at 2:40 p.m. in New York. The 10-year Treasury yield fell to 3.68 percent, from 3.70 percent.

`Mortgage Affordability'

Bloomberg current-coupon indexes represent the average of yields for the two groups of mortgage bonds with prices just above and below face value, the ones lenders typically package new loans into. The spread helps determine the rates offered to homeowners on new prime mortgages of $417,000 or less in most areas, and up to $729,500 in high-cost counties.

Paulson also said yesterday that the government would examine the fees Fannie and Freddie charge to guarantee home-loan securities. That also may help reduce mortgage rates, Merrill Lynch & Co. mortgage-bond strategists Akiva Dickstein and Craig Perkins wrote in a report.

The government will review the charges with ``an eye toward mortgage affordability,'' Paulson said. Fannie had planned on Oct. 1 to double to 50 basis points an upfront ``adverse market delivery charge,'' introduced this year for every mortgage the company buys or guarantees.

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

Last Updated: September 8, 2008 17:27 EDT