Fed Focuses on Consumer, Corporate Rate Spreads Over Treasuries

By Craig Torres

Jan. 6 (Bloomberg) -- Federal Reserve officials are focused on driving down the spreads between U.S. Treasury yields and consumer and corporate loans, after cutting the main interest rate to almost zero failed to revive lending.

Credit costs for households and businesses haven’t followed yields on government debt lower. Fifteen-year fixed-rate mortgages were at 5.06 percent last week, 2.59 percentage points above 10-year Treasury yields; the spread averaged 0.88 point in 2003, when the Fed slashed rates to 1 percent.

Chairman Ben S. Bernanke sees the thawing of frozen credit markets as critical to a recovery, and is determined to try to prevent a second wave of credit distress as the U.S. weathers bad economic news over the next two quarters. The Fed is now looking at ways to revive lending by using its balance sheet to hold loans and bonds that investors don’t want.

“Investors in general don’t want to take on the risk,” said Richard Schlanger, who helps manage $15 billion in fixed income securities at Pioneer Investments in Boston. “It is going to reach the point where the Fed will intervene again.”

One of the options under consideration: reviving the asset- purchase plan originally envisaged under the $700 billion Troubled Asset Relief Program run by the Treasury. The purchases could be combined with fresh injections of capital into banks, and the use of TARP money to help struggling home owners avoid foreclosure.

Obama Team

President-elect Barack Obama’s transition team and central bank officials have discussed such a strategy. Obama, who has advocated a broad-based approach to tackling the issue, takes office Jan. 20. He has picked New York Fed President Timothy Geithner as his Treasury chief, with former Treasury Secretary Lawrence Summers as White House economics director.

The Fed may today offer further insight into officials’ deliberations last month on shifting to using the amount and type of debt the central bank buys as the main tool of monetary policy. Minutes of the Dec. 16 Federal Open Market Committee meeting are scheduled for release at 2 p.m. in Washington.

At that session, the FOMC reduced its target rate for overnight loans between banks to zero to 0.25 percent, the lowest level on record. The panel also indicated readiness to expand programs to alleviate the credit crunch, or set up new ones, such as direct purchases of Treasuries.

Mortgage Bonds

The Fed yesterday began a frontal attack to drive down home-loan costs, buying mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae. The effort was part of a $600 billion plan, which also includes purchases of Fannie and Freddie bonds.

Mortgage rates “should be in the low 4s right now based on Fed rates,” said Ben Fox, executive vice president of Premier Mortgage Co. in Fairfax, Virginia. “They are not even close.”

Even after a $1.34 trillion increase in assets on the Fed’s balance sheet last year, private borrowing costs remain at unusually high spreads over U.S. Treasury benchmarks.

Gauges of corporate borrowing costs, which reached record levels in the fourth quarter of 2008, remain three to five times their long-run averages.

The spread on investment-grade corporate bonds is 6.03 percentage points, down from a record 6.56 percentage points on Dec. 5, Merrill Lynch & Co. data show. That compares with an average of 1.23 percentage points in the previous decade.

‘Worst’ Still Ahead

“With the likelihood that the worst news is ahead of us -- as far as the economy, corporate earnings and bankruptcies -- investors are hard-pressed to take on more portfolio risk at this time,” said Keith Wirtz, Cincinnati-based chief investment officer at Fifth Third Asset Management, which manages about $21 billion.

Financial companies around the world have already logged $1.1 trillion in losses and writedowns since the subprime mortgage crisis roiled markets from August 2007. A deteriorating economy means that figure is likely to keep rising.

Macroeconomic Advisers LLC, a St. Louis forecasting firm, estimates the economy contracted at a 5.5 percent annual rate in the fourth quarter, the worst performance since 1982.

Laurence Meyer, a former Fed governor and a founder of Macroeconomic Advisors, said purchases of longer-term Treasuries by the Fed would help keep yields down even as the Obama administration implements its planned fiscal stimulus.

The economic recovery package may be at least $800 billion. Obama “indicated that there’s at least 20 economists that he’s talked with, and all but one of those believe it should be from $800 billion to $1.2 trillion or $1.3 trillion,” Senate Majority Leader Harry Reid said after meeting with Obama yesterday.

‘Potent’ Policy

“The Fed will want to make monetary policy as potent as it possibly can be” by holding down long-term yields, Meyer said. “I certainly don’t think the Fed is done.”

Among other options for the Fed are expanding its planned $200 billion program to finance new securities backed by credit- card, automobile and student loans. That effort, supported with TARP money, is scheduled to start in early February, and the central bank has said it could be widened to include commercial mortgage-backed securities.

Another scenario is using the TARP to remove toxic assets from banks’ balance sheets. The Treasury, possibly in combination with the Fed, could buy the securities, insure them on banks’ balance sheets -- as officials did with Citigroup Inc. in November -- or set up a so-called bad bank to take on the investments.

One challenge: the amount of purchases required to clear the securities would be so big that it could dwarf the remaining TARP funds, which are now less than $350 billion.

Treasury Secretary Henry Paulson originally envisaged using the $700 billion authorized by Congress under the TARP in October to buy troubled assets. He quickly shelved that plan as the crisis intensified, instead opting to directly put capital into the banks in exchange for preferred shares and warrants.

The Washington-based Institute of International Finance, which represents the world’s largest commercial and investment banks, has called for revival of the asset purchase plan, arguing that it would help restore the health of the financial system.

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