Paulson Aims to Do What Eluded Fed: Get Banks to Lend

By Craig Torres

Sept. 8 (Bloomberg) -- Henry Paulson is making a colossal bet that the U.S. Treasury can do what Ben S. Bernanke's Federal Reserve failed to do: Get banks to lend more freely when the deteriorating economy is still telling them to hold back.

Paulson's gamble is that government control of Fannie Mae and Freddie Mac, the two biggest purchasers of home loans, will foster a liquid market for mortgage securities that will encourage lower rates and induce banks to lend. The risk is banks will still balk because the fundamentals underlying housing have soured. Unemployment is rising, real earnings have fallen, and house prices haven't broken an 18-month streak of declines.

``If the housing market doesn't turn around, then Fannie and Freddie become bad assets,'' said Vincent Reinhart, former director of the Fed's Monetary Affairs Division. ``Paulson sold this to Congress as, `Give me a blank check and I won't have to write it.' The question now is: How big is that check going to have to be?''

The Fed cut the benchmark lending rate 3.25 percentage points to 2 percent over the past year and provided billions of dollars in financial backstops to Wall Street investment firms and banks. The actions failed to lower interest rates on mortgages, leaving home values in a free-fall that created a vicious circle where credit became even harder to obtain.

The weekend announcements followed a crescendo of news showing the housing recession spilling over into the broader economy. Reports on Sept. 5 showed the U.S. unemployment rate climbed to a five-year high in August and average hourly earnings after inflation fell for the ninth consecutive month. Foreclosure rates reached the highest in 29 years of record- keeping.

New Wave of Risk

The worsening economy injected a new wave of credit risk into funding markets for banks, which they in turn translated into higher costs for borrowers.

Thirty-year mortgage rates averaged 6.35 percent in the first week of September, according to data compiled by Freddie Mac, almost matching the 6.34 percent they averaged when the Fed began its campaign of reducing its benchmark rate a year ago.

The government conservatorship of Fannie Mae and Freddie Mac may reduce spreads on mortgage bonds by assuring banks they will have an active secondary market for the new loans they make. What's more, the Treasury has agreed to buy the two companies' mortgage bonds.

No Guarantee

That in itself doesn't guarantee that mortgage rates will fall low enough to pull home prices out of their tailspin.

``The key question'' is whether the week's actions will bring a bottoming in the housing market, says Charles Diebel, head of European interest-rate strategy at Nomura International Plc in London. ``We would suggest the answer is no, but it does mean it will continue to function.''

The Treasury's rescue plan limits the growth of the two agencies' portfolios of home loans and mortgage-backed securities, capping them at $850 billion each as of December 2009. That allows them to expand their combined holdings by $144 billion over 16 months, compared with where they were on July 31. After 2009, the two agencies' balance sheets will begin to decline at a rate of 10 percent a year until they reach $250 billion each, under the Treasury's plan.

The Treasury also said it will purchase mortgage-backed security assets issued by the agencies, providing liquidity for banks who want to make new home loans and then sell them off.

Taxpayer First

Treasury said there is no reason to expect taxpayer losses from the program. ``The taxpayer will be repaid if we put something in before the shareholders get paid,'' Paulson said in an interview with Bloomberg Television. ``The taxpayer will come first.''

For now, the Treasury's immediate risk is limited to the performance of the $5 billion it plans to invest in the companies' mortgage bonds. The larger implied risk is in the backstops the Treasury has pledged.

If the Federal Housing Finance Agency determines that Fannie or Freddie's liabilities exceed their assets, ``Treasury will contribute cash capital'' to make the agencies solvent, the Treasury said yesterday.

Ultimately, whether the Treasury has to take that step depends on the performance of the housing collateral that underlies the securities.

``It's not a silver bullet,'' said Ajay Rajadhyaksha, head of fixed-income strategy at Barclays Capital Inc. in New York. ``The only way in which this helps the housing market is if it gets agency rates down a lot. That might not be as easy to achieve as it appears.''

Unsold Properties

Sales of previously owned homes in the U.S. rose in July from a 10-year low, not enough to whittle away a glut of unsold properties that's weighing on prices.

There were 4.67 million unsold houses and condos on the market in July, representing 11.2 months supply, about double the inventory of a stable market, according to the National Association of Realtors. Home prices nationally were down 18 percent in the second quarter from their peak two years earlier, according to the S&P Case-Shiller home-price index.

``What do these two agencies own? Mortgages on U.S. houses,'' said Mark Spindel, chief investment officer of Washington-based Potomac River Capital LLC. ``To the extent that house prices were to fall further, the value of the assets the government just acquired could fall further.''

To contact the reporter on this story: Craig Torres in Washington at ctorres3@bloomberg.net