By Craig Torres
Oct. 31 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke said the market for mortgage-backed bonds will require some form of government support through either guarantees or insurance programs to weather times of heightened stress.
The Fed chief also said Fannie Mae and Freddie Mac, the largest sources of money for U.S. home loans, should retain some form of government support and oversight even if the companies are transformed from their current federal conservatorship to become private companies.
Bernanke's comments suggest he sees a permanent role for government support of homeownership through mortgage finance. Those views contrast with such free-market advocates as Alan Greenspan, who has urged an end to official support for Fannie and Freddie. Bernanke said the current crisis shows there wouldn't be a mortgage securities market without some government backing.
``The U.S. government's strong and effective guarantee of the obligations issued under the current government-sponsored enterprise structure must be maintained,'' Bernanke said today in remarks to a conference in Berkeley, California. ``If the GSEs were privatized, it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil.''
Government Takeover
Treasury Secretary Henry Paulson engineered the seizure of Fannie Mae and Freddie Mac on the weekend of Sept. 7 after the biggest surge in mortgage defaults in at least three decades threatened to topple the companies. Bernanke raised a number of scenarios for the future of the companies, without stating which option he prefers.
Securitization, the process where home loans are packaged together into a bond and sold to investors, is important because it allows banks to distribute risk and provides a wider pool of capital to finance mortgages, Bernanke said.
One approach would be to create a government bond insurer which would allow issuers to obtain a government guarantee for their bonds for a fee, the Fed chief said.
``This new agency would offer, for a premium, government- backed insurance for any form of bond financing used to provide funding to mortgage markets,'' Bernanke said. Mortgage securities ``issued by the privatized GSEs as well as mortgage- backed bonds issued by banks would be eligible.''
The Fed chairman's comments suggest he believes that a market based on borrowers with anything but high credit ratings would remain fragile and in need of some government support, investors said.
`Perpetual' Backstop
``To require a perpetual government backstop is to say we are going to have perpetually inadequate underwriting standards,'' said Julian Mann, who helps manage about $10 billion as vice president at First Pacific Advisors LLC in Los Angeles.
Bernanke also discussed the option of covered bonds, while noting that they might be less competitive with existing finance options. Covered bonds offer banks a way to raise money for new mortgages without either selling the loans or packaging them into securities. Instead, a bank issues bonds that are backed by a dedicated and regularly updated pool of loans, which stay on the bank's balance sheet.
Another alternative for Fannie Mae and Freddie Mac would be a public-utility model, where the two remain as shareholder- owned corporations and are overseen by public boards, Bernanke said.
Folded Into FHA
``Beyond simply monitoring safety and soundness, the regulator would also establish pricing and other rules consistent with a promised rate of return to shareholders,'' he said. The two companies could be folded into the Federal Housing Administration and become full government agencies that securitize mortgages, such as the Government National Mortgage Association, he said.
The Fed chairman didn't discuss interest rates or the economy in the text of his remarks.
The Fed cut the main interest rate this week to a half- century low of 1 percent to limit damage from the collapse of the U.S. mortgage market and avert what may be the worst recession in a quarter century.
Washington-based Fannie and McLean, Virginia-based Freddie own or guarantee nearly half the $12 trillion in U.S. residential mortgage debt outstanding.
The Treasury agreed last month to inject up to $100 billion apiece in Fannie and Freddie to keep their net worth positive. Freddie's book value stood at $12.9 billion at the end of June, while Fannie's stood at $41.2 billion.
Potential Writedowns
Eliminating Freddie's $18.4 billion in deferred tax credits would leave it with a book value of negative $6 billion and would cut Fannie's net worth in half, before factoring in other potential writedowns, analysts said.
Bernanke noted that markets for GSE debt and mortgages have come under stress in recent days ``because of widespread dislocations in financial markets generally.''
Yields on Fannie Mae and Freddie Mac corporate debt fell relative to benchmarks following Bernanke's remarks.
The difference between yields on Washington-based Fannie's 10-year debt and similar-maturity Treasuries fell 6.9 basis points to 121 basis points as of 2:30 p.m. in New York, after earlier falling as low as 119 basis points, according to data complied by Bloomberg.
Richmond Fed President Jeffrey Lacker has endorsed the view of former Fed Chairman Greenspan that the government should nationalize Fannie Mae and Freddie Mac before splitting them up and selling them off.
`Credibly' Privatized
``I would prefer to see them credibly and demonstrably privatized,'' Lacker said in an Aug. 20 interview with Bloomberg Television.
Bernanke said it's an ``open question'' whether the GSE model ``is viable without at least implicit government support.''
``Private-label securitization has largely stopped,'' Bernanke said. The fact that GSE issuance continued suggests ``at least under the most stressed conditions, some form of government backstop may be necessary to ensure continued securitization of mortgages,'' he said.
Paulson hasn't taken a position on the future of the two mortgage finance companies beyond their current status under federal conservatorship, where they are overseen by the government while remaining shareholder-owned.
Economy Worsens
U.S. foreclosure filings rose to a record in the third quarter, and will probably increase as the economy worsens and the availability of financing shrinks, RealtyTrac Inc., a seller of default data, reported on Oct. 22.
Almost 20 percent of U.S. mortgage borrowers owed more on their loans during the third quarter than their house was worth as foreclosures depressed prices and the economy weakened, according to First American CoreLogic, a Santa Ana, California- based seller of economic and real estate data.
Borrowing costs have remained high. U.S. 30-year mortgage rates tracked by Freddie Mac rose to 6.46 percent this week, up from 6.04 percent the previous week and 6.07 percent on Jan. 3. Banks are unlikely to compete for new loans and offer lower rates so long as the outlook for the economy remains dim, economists said.
To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net
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