Treasuries Fall as Fed to Accept Mortgage Debt as Collateral

By Sandra Hernandez and Deborah Finestone


March 11 (Bloomberg) -- Treasuries fell, pushing two-year note yields up the most since March 1996, as the Federal Reserve's move to relieve the credit crisis prompted investors to dump holdings of government debt.

Notes maturing in five years or less led the decline as the central bank said it will allow its 20 primary dealer firms to pledge agency and private mortgage debt as collateral against as much as $200 billion in Treasuries in weekly auctions. U.S. stocks rallied on the Fed's announcement, with the Standard & Poor's 500 Index rising the most since 2002.

``The Fed is trying to do anything it can to free up markets,'' said Jason Brady, a managing director in Santa Fe, New Mexico, at Thornburg Investment Management, which oversees $4 billion in fixed-income assets. ``People have been in asset- preservation mode. To the extent we shift away from that mode, you sell Treasuries.''

The two-year note's yield climbed 28 basis points, or 0.28 percentage point, to 1.78 percent at 4:29 p.m. in New York, according to bond broker Cantor Fitzgerald LP. The price of the 2 percent security due in February 2010 dropped 18/32, or $5.63 per $1,000 face amount, to 100 14/32.

The yield increased the most since March 8, 1996, when a government report showed the U.S. added twice as many jobs as economists forecast. The benchmark 10-year note's yield rose 16 basis points, the most since Feb. 7, to 3.62 percent.

Fed Rate Outlook

After the Fed's announcement, traders pared bets policy makers will cut the target rate for overnight lending between banks by three-quarters of a percentage point on March 18. Interest-rate futures on the Chicago Board of Trade showed a 64 percent chance of a 75 basis point cut, compared with 86 percent odds yesterday. The likelihood of a 1 percentage point reduction fell to zero from 14 percent yesterday.

The five-year yield increased 29 basis points to 2.66 percent today, the biggest gain since April 2004.

Five-year notes ``trade based on how quickly the Fed will take the cuts back,'' said Jason Stipanov, an interest-rate strategist in New York at Morgan Stanley. ``The fact that the Fed is aggressively addressing the funding situation means on the margin they may be able to reverse monetary policy more quickly.''

Two-year notes yielded 182 basis points less than 10-year notes, the narrowest difference this month. The spread increased to 208 basis points on March 6, the widest since 2004, as traders bought two-year notes on speculation the Fed would make deeper cuts in the benchmark rate.

Auction Collateral

Auctions of Treasuries that the Fed announced today, which will begin March 27, may be secured by collateral including AAA rated mortgage securities sold by Fannie Mae, Freddie Mac and banks. The Fed ``will consult with primary dealers on technical design features'' of the new tool.

The $200 billion of Treasuries to be lent covers all the agency and mortgage-backed securities held by primary dealers as of Feb. 27. Dealers held $139.7 billion in agency debt and $60.2 billion in mortgage bonds, according to the Fed.

``The Fed's facility literally is able to handle all of the agency securities and mortgage-backed securities that dealers hold,'' said Tony Crescenzi, chief bond market strategist at broker Miller Tabak & Co. in New York.

Under the new program, called the Term Securities Lending Facility, the Fed will lend Treasuries to primary dealers for 28-day periods through weekly auctions. The Fed also said in a statement in Washington that it's increasing the amount of dollars available to European central banks through swap lines.

`Richness of Treasuries'

``One of the things that's been driving the richness of Treasuries is that Treasury collateral has been trading at a premium,'' said Stipanov at Morgan Stanley. ``This is increasing the supply of Treasury collateral in the system, and the higher supply should generally cheapen Treasuries.''

The difference in yields on the Bloomberg index for Fannie Mae's current-coupon, 30-year fixed-rate mortgage bonds and 10- year government notes narrowed about 12 basis points to 216 basis points. The spread helps determine the interest rate homeowners pay on new prime mortgages of $417,000 or less.

Banks and securities firms have demanded more collateral on loans secured by debt from investment funds including Carlyle Capital Corp., forcing investors to sell assets to meet margin calls, and few buyers have emerged. The spread reached the highest level since 1986 on March 5.

Today's steps are the latest in Chairman Ben S. Bernanke's effort to alleviate increasing strains in financial markets that curtail the availability of credit to homeowners and companies.

Fed and Mortgages

``In effect, the Fed has gotten into the mortgage business, which ultimately is going to be quite stimulative to the economy,'' said Michael Aronstein, chief investment strategist in New York at Oscar Gruss & Son Inc., an institutional research and execution firm.

Three-month Treasury bill rates rose 12 basis points to 1.45 percent. The difference between what the government and companies pay for three-month loans, known as the TED spread, fell to 1.42 percentage points, the narrowest in a week. It touched 1.63 percentage points on March 6, the biggest difference since Dec. 27, reflecting banks' reluctance to lend.

The risk of losses on U.S. Treasury notes exceeded German bunds for the first time ever on concern the subprime mortgage crisis is sapping government reserves, credit-default swaps prices show. Contracts on 10-year Treasuries traded at a record 16 basis points earlier today, compared with 15 basis points on German government notes, according to data compiled by BNP Paribas SA.

Treasuries of all maturities have still returned 4.17 percent this year, according to an index compiled by Merrill Lynch & Co, while the S&P 500 has dropped 11.7 percent. Banks and securities firms worldwide have declared $188 billion of losses linked to the collapse of the U.S. mortgage market since the start of 2007.

The S&P 500 surged 3.7 percent today for the biggest rally since October 2002. The Dow Jones Industrial Average increased 3.6 percent.