Tightening global credit markets have taken a toll on U.S. mortgage-backed securities issued by Fannie Mae and Freddie Mac and it will take more than recent Federal Reserve measures to boost liquidity.

While the central bank's recent move to cut the primary discount rate boosted liquidity in financial markets overall, it may be too late to help the roughly $4.25 trillion agency MBS market.

Issuance in the primary agency MBS market should remain high as borrowers continue to switch out of floating-rate loans and into fixed-rate mortgages. But the secondary market, which is where the bonds trade, has been thrown into disarray in recent weeks.

Month-to-date, the yield spread on the MBS current coupon, the most actively traded issue, has tightened by about 0.04 percentage point to the 10-year Treasury note. But it has widened by about 0.11 percentage point to the five-year Treasury note, according to Arthur Frank, director and head of MBS research at Deutsche Bank Securities in New York.

That is a fairly significant move by most analysts' accounts and comes after a disastrous performance in July, when wider swap spreads and higher interest rate volatility caused the sector to put in one of its worst monthly performances against Treasuries on record.

The market is taking the cut in the discount rate as a signal that the Fed is paying attention and is concerned, but the main impact is primarily psychological, said Alec Crawford, head of MBS strategy at RBS Greenwich Capital in Greenwich, Connecticut.

LACKING LIQUIDITY

At roughly $7 trillion in size, which includes the subprime sector, the mortgage bond market is the world's largest, dominated by Fannie Mae and Freddie Mac.

Liquidity in the agency MBS market is not only worse than it was a few months ago, it is worse than it was a just a few weeks ago, said Deutsche's Frank.

Issuance of bonds backed by non-agency debt has come to a virtual halt as investors refuse to buy securities backed by anything whose payments are not guaranteed. But now, triple-A rated MBS issued by Fannie Mae (FNM.N: Quote, Profile, Research) and Freddie Mac

RBS Greenwich Capital's Crawford said there have recently been large differences between quotes on prices to buy and prices to sell agency MBS, indicative of a lack of liquidity.

The bid/ask spreads on mortgage bonds have certainly widened because the Street knows that a $300 million trade today is similar in risk to a billion dollar trade six months ago and that's because there's so much more volatility, he said.

When the Fed last Friday slashed the discount rate by half a percentage point, it also encouraged Wall Street banks to increase their borrowing. For the first time since volatility began to hit markets, the Fed also acknowledged that deteriorating credit conditions could slow economic growth.

Central banks worldwide have injected billions of dollars into financial systems as liquidity fears have swept through markets in widening fallout from the U.S. subprime mortgage crisis.

Eventually there will be some opportunities in mortgage bonds, but we're not in a position to jump in right now, said Daniela Mardarovici, principal and portfolio manager at Harris Investment Management, Inc, an autonomous subsidiary of Bank of Montreal, based in Chicago.

Mardarovici, who helps manage roughly $1.5 billion in MBS, is waiting for the market to settle down. When it does, she anticipates buying opportunities.

For now, we are staying neutral on the sector, she said.

CONGRESS OR THE FED?

Supply has weighed heavily on the MBS market for most of 2007 as borrowers shifted from adjustable-rate mortgages into fixed-rate loans. The recent weakness in non-agency mortgages relative to agency mortgages should add to supply pressures in agency MBS as originators shift more supply into this relatively more expensive market.

Liquidity in the MBS market will probably not ease going forward because $400 billion of agency and non-agency ARMs are resetting in each of the next three years, according to Matthew Jozoff, head of mortgage research at JPMorgan in New York.

With many of these being subprime borrowers, there will be a number of borrowers looking to refinance in a period of tighter lending standards and impaired liquidity, his team said in recent research.

Legislation, however, may buoy agency MBS.

On Tuesday, U.S. Senate Banking Committee Chairman Christopher Dodd said he asked the Bush administration to lift the portfolio caps on Fannie Mae and Freddie Mac, but Treasury Secretary Henry Paulson expressed reluctance to do so.

A lifting of the portfolio caps would be good for agency MBS since they would be buying more and providing a bid to the market that could cause spreads to tighten, Deutsche's Frank said.

History may yet repeat itself.

In the first half of October 1998, Fannie Mae and Freddie Mac came to the rescue of the mortgage bond market, buying a massive amount of agency MBS, which ultimately stemmed the market's dramatic cheapening.

In late 1998, the Fed made three rapid-fire rate cuts in the wake of the Russian financial crisis and the collapse of Long-Term Capital Management, one of the biggest financial crisis of the past 100 years.

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