Economists are reacting positively to the largest-ever financial rescue by the U.S. government - the takeover of mortgage giants Fannie Mae and Freddie Mac announced on Sunday. The deal should help to soften mortgage rates and make it easier for Americans to finance a home, which will contribute positively to the troubled housing market, economists say.

Writing before the markets opened on Monday morning, BMO senior economist Sal Guatieri said markets were giving the deal "two thumbs up, sensing it will restore confidence and shore up the economy." He noted that overseas equity markets moved up sharply by 3-5%, U.S. stock index futures erased last week's loss and moved up 3%, and the U.S. dollar was "strongly higher across the board."

As of 11:30 a.m. EDT, equity markets around the globe surged and the S&P 500 is up 1.5%. The U.S. dollar index also rose to an 11-month high and Treasuries sold off as investors seek riskier assets.

Richard Berner, chief U.S. economist at Morgan Stanley, said the key will the sustainability of the positive market reaction. "At the outset, we see this as a major positive for mortgage market and GSE spreads. In general, it is a near-term positive for risk assets, as investors are unwinding risk-aversion trades."

Berner said he's encouraged by the rescue plan and its potential effects on other risk assets. He said if the market reaction can be sustained, the takeover plan will probably help to reduce the slide in housing activity and home prices that threaten the overall economy. "Furthermore, this plan goes a long way to restoring confidence in the financial markets, the positive impact of which cannot be underestimated," he said.

Global Insight's chief U.S. financial economist Brian Bethune said the takeover will be bad news for existing shareholders but good news for American households: first-time homebuyers will benefit from lower mortgage rates, as will those who can refinance their mortgage. He said there is a "very high probability that 30-year fixed mortgage rates could move down to close to 6% within weeks, and possibly drop below that level by the end of 2008."

Bethune also said the deal makes the implicit guarantee of the government on GSE debt more explicit, and a result he expects to see a significant decline in GSE funding spreads.

"Our best guess is that funding spreads could drop by 40-50 basis points from average levels of about 80 basis points on 20-year debt in the past six weeks," he said, noting that a drop in mortgage rates should provide an affordability boost in addition to the declining prices seen over the past two years.

Looking at the negative consequences, Eric Lascelles, senior rates and economics strategist at TD Securities, said government action always runs the risk of moral hazard by setting the expectation that there could be further bailouts in the future.

He said the action over the weekend erases the worst-case scenario for large firms and the onus is on the government to create regulations to prevent other large firms from depending on the too-big-to-fail argument; on the other hand, he said the political calculation in this scenario - that the benefits of saving the GSEs outweigh the costs - is certainly correct and there wasn't much alternative for the government.

Ian Lyngen, fixed income strategist at RBS Greenwich Capital, said the market's warm response is a "knee-jerk reaction from the Treasury market," noting that while the GSE reforms "will surely ultimately support the mortgage market, the near-term real economic impact will be limited."

Lyngen said he can't see this move becoming a pivotal event in the markets - even if it's a policy one. He said attention will quickly turn to important data coming out later in the week, such as retail sales and the producer price index.

By Patrick McGee and edited by Nancy Girgis
©CEP News Ltd. 2008