Treasury to the rescue: 4.5% mortgage interest rate?

Today Wall Street Journal revealed that the Treasury Department is mulling a plan to bring down mortgage interest rate to as low as 4.5%. According to WSJ, this can be accomplished by direct purchasing of new mortgages by the Treasury through Fannie and Freddie. You know what? This is a fantastic idea. Only the Wall Street type would come up with this great idea. The Treasury is headed precisely by a Wall Street pro, Hank Paulson. (No, I am not being sarcastic here. I mean it. Finally, some real good idea came out of there.)

How does this work? Let me explain.

Right now the Treasury Bonds are trading at an extraordinarily low interest rate. Yield on the 30-year T-Bond is below 3.1%, while yield on the 10-year bond is around 2.6%. That means the Treasury right now can borrow money at very low cost. In the meanwhile, the interest rate on Mortgage debt is relatively high. A 30-year conforming loan right now is yielding around 5.3%. In the Wall Street lingo, the "spread" between Treasury and Mortgage is very wide, at least 2.2% (5.3%-3.1%).

What if Treasury borrow money from the financial market by selling Treasury Bonds at an interest cost of 3.1%, and then use the money to buy mortgage debt that generates a much higher interest income. The higher interest income the Treasury would get from the Mortgage investment would more than enough to pay for the borrowing cost on the Treasury Bonds, still leaving a smart chump for the Treasury.

How much the Treasury could make if it indeed decides to go ahead with such a plan? The Treasury will not buy all mortgages. It will buy only high quality conforming mortgages, minimizing default risk. Total market for these mortgage loans could be more than $600B/year. Let's assume that the Treasury would buy $100B of these Mortgage loans at a target interest rate of 4.5%. On the other hand, the Treasury would have to first issue $100B Treasury Bonds, probably at a higher cost than current, say 3.5%. So the spread would be a full 1%, which translates into $1B net interest income per year for the Treasury.

Secondary effects of these transactions would be very positive. Home sales would go up because of the attractive interest rate. Existing mortgages should be repriced because of thawing up of the mortgage market. Indirectly banks would be helped because their mortgage investments will regain liquidity. I think this is a great idea. This is an idea that would first help homeowners and also help the financial institutions. So far the $700B Bank Bailout Plan (the "trickle-down/top-down plan", as I would call it) has not produced the desired result. Banks are hoarding the cash they got from the government, instead of lending out to businesses. Credit market has not seen any much loosening so far. I believe this proposed plan, (a "bottom-up plan" as I would call it) would produce the desired result: loosening up the credit market.

One caveat remains: the money Treasury would get from Mortgage payments should go back to pay down the debt it borrowed in the first place. The government cannot get its hand on this bucket of money for other budget use. Any profit from the transaction should also be used to pay down the government debt. This way, we would not end up creating another inflationary bubble.