Market Recap

Sometimes sacrifices must be made, though that sentiment is of little comfort when you are the one being sacrificed. Take shareholders in government-sponsored entities (GSEs) Fannie Mae and Freddie Mac, for instance. They saw their equity sacrificed after both entities were taken over by the federal government last week.

The effects of the takeover were immediately salubrious – for the mortgage market. Rates tanked after the announced takeover. Bankrate.com's latest survey showed that the 30-year fixed-rate mortgage fell 40 basis points to 6.15%, the 15-year fixed-rate mortgage fell 28 basis points to 5.81%, and the 5/1 adjustable-rate mortgage fell 21 basis points to 6.08%.

So why the sudden rate drop? The takeover means that the Treasury Department is promising to buy mortgage-backed securities issued by the aforementioned GSEs. This promise assures private investors in mortgage-backed securities of repayment of both principal and interest, which is why mortgage rates dropped so precipitously. In essence, the government assumed the roll of buyer of last resort. This guaranteed demand provides a floor for mortgage-backed securities prices. That floor, in turn, elevated prices, and when mortgage-backed securities prices rise, yields fall.

It remains to be seen whether the mortgage market's windfall will eventually blow over to the housing market, which is certainly due a small windfall of its own. Pending home sales remain flat, with the pending home sales index holding at 86.5. NAR Chief Economists Lawrence Yun says, rather discouragingly, that “even with the direct intervention in the secondary mortgage market, it is unclear if we will go back to sound normal underwriting criteria, or if it will remain overly stringent.”

Let's root for normal underwriting criteria.

Winners and Loosers

Not everyone associated with Fannie Mae's and Freddie Mac's capital structure was sacrificed last week. The U.K. Telegraph reported that the Treasury Department's move to place Fannie and Freddie into conservatorship netted PIMCO, a bond investing outfit, an immediate $1.7 billion profit. What's more, PIMCO wasn't the lone winner. Nomura Asset Management, T. Rowe Price Group Inc., RiverSource Institutional Advisors and FAF Advisors also netted a tidy profit, having bought nearly $1 trillion in both agencies' debt this past July.

Perhaps a similar replay will unfold this week. Lehman Brothers Holdings, another financial firm buried under low-quality subprime mortgage paper, is actively shopping itself to potential buyers, aided by both the U.S. Treasury and Federal Reserve, meaning the U.S. Government is orchestrating its second major bailout in as many weeks. Goldman Sachs and Bank of America are the current front-runners in the Lehman stakes. Regardless of who eventually wins, Lehman shareholders are sure to receive the short-end of the stick, while certain Lehman bondholders could find themselves receiving the long-end.

A Lehman bailout won't have the same mortgage market impact as the Fannie Mae and Freddie Mac bailouts, but it will affirm the notion that government can, and does, game winners and losers. Let's just hope the government's willingness to be the financial sector's savior will help the mortgage and housing markets remain long-term winners. It will be reassuring to know that the current machinations will benefit more than just your well-connected bond trader.