The Federal Reserve's attempts to provide liquidity in the past few days are not reaching the players who need it since they cannot borrow directly from the central bank, leaving the $7.2 trillion U.S. mortgage bond market struggling to clear the volumes being offered.

Last Friday the Federal Reserve cut the discount rate at which banks can borrow directly from the central bank by 0.5 percentage points to 5.75 percent. The Fed has also injected about $100 billion of extra liquidity into the banking system in its daily open market operations in the past week.

The moves were initially cheered by world stock markets, but failed to curb the flight to the quality and liquidity of U.S. Treasury bills and bonds that has seen the U.S. Treasury 2-year note fall to its lowest yield in nearly two years.

Losses emanating from the U.S. subprime mortgage market have hit the balance sheets of banks and funds around the world in recent weeks and created the worst credit and liquidity squeeze in world financial markets in a decade.

The Fed is spraying the fire but it's hitting the houses around the fire, said Michael Youngblood, a managing director at FBR Investment Management in Arlington, Virginia.

Parts of the mortgage bond market were conspicuously inactive on Monday after digesting the Fed's moves and appear slower today, he said.

Non-agency bonds that are typically high quality but not guaranteed by government-sponsored enterprises Fannie Mae and Freddie Mac were the subjects of bid lists seeking buyers this week, he said.

More than $20 billion worth of non-agency mortgage bonds, which made up about a fifth of the market in the first quarter, have been offered for sale in the past few days, analysts said, and there may more to come if lender balance sheets continue to be cleared in a hurry.

On Monday, one list of more than $500 million non-agency adjustable-rate mortgages drew offers as low as 93.5 cents on the dollar, Youngblood said.

Top-rated prime mortgage bonds drew prices near 100 just weeks ago, slipping only after AAA rated portions of subprime bonds tumbled in July.

Thornburg Mortgage Inc.'s announcement on Monday that it sold more than 35 percent of its mortgage assets seemed to confirm views that the Fed's move won't reach the non-agency market, analysts said.

Even though the Santa Fe, New Mexico-based lender specializes in prime jumbo loans that have not shown the credit erosion seen in subprime and Alt-A mortgages, the mortgage real estate investment trust (REIT) has still had funding problems..

San Francisco-based Luminent Mortgage Capital dealt with its funding troubles with a $60 billion capital injection from Arco Capital Corp., which will also buy $65 million of the company's mortgage assets, it said on Monday.

Friedman, Billings, Ramsey Group, another real estate investment trust, on Monday said it sold $4.95 billion in agency mortgage bonds.

In the subprime sector, Accredited Home Lenders Holding Co. on Tuesday said it would sell $1 billion in loans.

Right now there seems to be something of a pause, said Arthur Frank, head of mortgage research at Deutsche Bank AG in New York, of late morning trading.

The particular large REIT liquidation appears to be over, but we don't know how much supply is behind it from other investors.

Many mortgage bond holdings are financed by the short term commercial paper market, but last week financiers began to balk at the quality of the collateral they were offered as fears grew that soaring delinquency rates in subprime lending have spread to better quality loans.

Five large REITs, including Thornburg, own $125 billion in mortgage assets and finance much of their holdings with commercial paper, according to JPMorgan.

The problem for many lenders, including Thornburg, is that they rely on private funding sources and cannot borrow directly from the Fed, and so are being forced to sell assets to raise cash, analysts said.

This flood of supply will pressure all sectors of the mortgage market, as investors and dealers are forced to sell other assets to absorb those, JPMorgan said in a note.

Wall Street firms that profit from trading in the securities over the weekend noted value in the top-rated non-agency mortgage bonds that have been pummeled relative to those in the more standardized and larger agency MBS market. There was limited buying at yield spreads as much as 0.25 percentage point wider, Deutsche's Frank said.

Slack demand even for mortgage bonds backed by homeowners current in their payments bodes poorly for securities linked to loans whose performance continues to deteriorate, said Scott Simon, a managing director at Pacific Investment Management Co. in Newport Beach, California.

Hedge funds and other investors forced to sell subprime assets have mostly unloaded higher-rated assets to minimize realized losses.

A lot of liquidations have been in very high quality, fairly simple assets, Simon said. Going forward, you'll see much more dubious credit and less liquid and harder to value securities come out.

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