Fears that the government will be forced to bail out Fannie Mae and Freddie Mac may actually be helping drive mortgage rates down, an effect that could be dampened as investors rush back into the stock market this week.

The average rate on a 30-year fixed-rate mortgage was 6.26 percent with an average of 0.6 point for the week ending July 17, down from 6.37 percent a week ago and 6.73 percent at the same time last year, Freddie Mac said in its weekly mortgage market survey. Rates on 15-year fixed-rate mortgages were also down, falling from 5.91 percent a week ago to 5.78 percent with an average 0.6 point.

Adjustable-rate mortgage (ARM) loans showed less dramatic reductions, with the rate on five-year Treasury-indexed hybrid ARMs averaging 5.8 percent with an average of 0.6 point, down from 5.82 percent last week and 6.35 percent a year ago. One-year Treasury-indexed ARMs averaged 5.1 percent with an average of 0.6 point, down from 5.17 percent last week and 5.72 percent a year ago.

Looking back to the week ending July 11, the Mortgage Bankers Association said mortgage applications were up 1.7 percent from the previous week, but down 17.4 percent from a year ago. Refinance applications increased to 39.2 percent of applications, up from 37.3 percent the week before.

With Fannie Mae and Freddie Mac purchasing or guaranteeing about three out of four loans, it might seem counterintuitive that fears about their future could lead to lower mortgage rates.

Shareholders in Fannie and Freddie might be harmed if the government were forced to buy a stake in the government-chartered companies or loan them money. But the government’s stated willingness to provide a capital backstop has reinforced the perception that it stands behind the companies’ debt, said Tom Millon, chief executive officer of Capital Markets Cooperative, a Ponte Vedra Beach, Fla.-based firm that helps lenders sell loans in the secondary market.

"This whole Fannie and Freddie debacle may end up helping mortgage rates at the end of the day," Millon said.

Ironically, this week’s stock market rebound — driven in part by a sharp decline in oil prices and a better-than-expected second-quarter earnings report from Wells Fargo — could put upward pressure on interest rates including mortgages, Millon said.

Two broad issues determine mortgage rates, Millon said. Macroeconomic trends can drive investors into safe investments like Treasury notes when investments like stocks look too risky. A flood of investment dollars into Treasurys pushes their prices up, effectively lowering yields. A flood of investment in Treasurys can also push mortgage rates down, because the bonds and securities that finance mortgage loans compete with Treasurys for investment dollars.

In addition to macroeconomic trends, the other broad issue affecting mortgage rates is the "spread" between the return on Treasurys and investments backed by mortgages. The spread — currently about 2.5 percent, Millon said — reflects the degree to which investors consider mortgage-backed securities to be riskier than Treasurys.

There are two main components to the spread between Treasurys and mortgage-backed securities. One is credit risk — the chance that borrowers won’t be able to make their payments and that if anybody is guaranteeing those payments, they will be able to fulfill that guarantee.

The other major component of the spread is prepayment risk — the chance that borrowers will refinance their mortgage when interest rates fall.

During the housing boom, the spread between Treasurys and investments backed by Fannie and Freddie was considerably lower, because investors were more worried about prepayment risk than credit risk.

When the number of homeowners defaulting on their loans picked up, the credit risk component of the spread between Treasurys and mortgage-backed securities — especially those not guaranteed by Fannie and Freddie — widened considerably. As the credit crunch worsened, investors saw increased credit risk even with investments guaranteed by Fannie and Freddie, and demanded higher returns to compensate.

Now, "With the government standing more strongly behind Fannie and Freddie, some of that credit risk has gone away," Millon said. "Some of this mess has actually been good for mortgage rates."

But while this week’s stock market rally has been a welcome reprieve for Fannie and Freddie, banks and mortgage insurers — many of which still need to raise capital to offset housing-related losses — it also means investors are less eager to buy Treasurys and mortgage-backed securities.

"In the last two days, Treasury rates have spiked up because there’s a little breath of hope things will get better," Millon said. "Whether this is a little head fake and things will get worse again, who knows?"

For now, investment dollars are flooding back into the stock market and out of safer investments like Treasurys, depressing bond prices and driving yields up. Because mortgage-backed securities compete with Treasurys for investment dollars, the stock market’s rebound could push mortgage rates up, too — although the impact could be offset by the reduction in spread.

The other macroeconomic trend to watch for its influence on mortgage rates is inflation.

Freddie Mac’s chief economist, Frank Nothaft, thinks another reason mortgage rates fell this week was market speculation that the Federal Reserve may decide to combat inflation by raising the overnight bank-lending rate this year after all.

Although Fed chairman Ben Bernanke said this week that inflation is still a major concern and the economic outlook remains uncertain (see story), oil prices are coming down from recent peaks, which could relieve pressure on the price of other, related goods.

Nothaft said other factors motivating the change in market perceptions this week included sluggish growth in retail sales during June and consumer sentiment holding in July at lows not seen since 1980.


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