Collateral Damage Could Include Higher Mortgage Rates

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The Wall Street Journal
By: Nick Timiraos
August 8, 2011

Mortgage markets in the U.S., which remain on government life support, could be rattled by the downgrade of the U.S. credit rating, potentially raising borrowing costs for consumers.


Given the "sufficiently perilous" state of the U.S. mortgage market, a downgrade "can do nothing but harm the market," says Karen Shaw Petrou, managing partner of Federal Financial Analytics, a research firm in Washington. "The question is how much?"

Standard & Poor's warned last month that a downgrade of the U.S. credit rating likely would trigger a downgrade of mortgage-finance giants Fannie Mae and Freddie Mac. The firms were effectively nationalized three years ago, and they've maintained their triple-A rating only because the government has effectively guaranteed their debt.

To be sure, no one knows for certain the impact of the unprecedented downgrade on the mortgage market, even if that market is fundamentally intertwined with the federal government.

Securities issued by the Government National Mortgage Association, or Ginnie Mae, a government-owned corporation, have been rated triple-A as a direct result of the U.S. government's rating.

Nearly nine in 10 new mortgages are backed by Fannie, Freddie, or Ginnie.

Fannie and Freddie own around $1.5 trillion in mortgages on their balance sheet which they fund with corporate debt often called "agency debt" or "agencies." The government backstop enables the firms to borrow cheaply.

If the firms' rating were to be downgraded, and that in turn increases their borrowing costs, that could lead to higher mortgage rates or cause losses for the firms, which have cost taxpayers $141 billion and counting.

Fannie and Freddie also guarantee another $4 trillion in mortgage-backed securities that are held by investors.

Those securities aren't rated and trade as safe investments due to the government backing.

Because the government's underlying support of Fannie and Freddie hasn't changed, the downgrade could be a "non-event" for the mortgage market, said Ajay Rajadhyaksha, a managing director at Barclays Capital.

"Agency debt has for the last several years been supported by the balance sheet of the U.S. government. That balance sheet has not degraded today simply because of the downgrade," he said.

One concern is that downgrades may trigger forced selling by mutual funds or foreign investors to comply with investor-specific capital requirements restricting them to assets rated triple-A.

But analysts said that most institutional investors' rules for investing in government-backed mortgage debt aren't contingent on ratings.

And with investors seeking traditional safe-haven assets such as Treasurys and government-backed mortgage securities, "there just doesn't seem to be much else to invest in," says Andrew Davidson, a mortgage-industry consultant in New York. "What would people put their money in if they sold their agency mortgages? It's hard to see what the trade is."

Mortgage rates are closely tied to yields on the 10-year Treasury note. Rising demand for Treasurys pushed down yields over the past two weeks, even as the threat of a U.S. default from the debt-ceiling debate in Washington dragged on, because investors looked for less risky assets amid concerns over the European debt crisis and the sluggish U.S. economy.

"The worry about getting your money back wasn't as big as the fact that the economy was slowing," says Scott Simon, a managing director at Pacific Investment Management Co., or Pimco, a unit of Allianz SE.

Mortgage rates dropped to an eight-month low last week, with 30-year fixed-rate mortgages averaging 4.39% for the week ended Thursday, according to a survey by Freddie Mac.

Still, the uncertainty created by the downgrade has investors on edge.

The interplay of a downgrade, on top of the euro-zone crisis and renewed fears over a double-dip recession in the U.S., could lead to increased volatility in mortgage markets.

"There are so many moving parts to this that no one really knows how it will go," says Mr. Simon.

Write to Nick Timiraos at nick.timiraos@wsj.com

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