The new mortgage plan: Get rates to 4.5% at all costs!

We've seen some additional reporting overnight on how this new proposed program from the Treasury to drive down mortgage rates will work. Apparently, the idea is to have Fannie Mae and Freddie Mac pay high prices for loans from lenders. This would allow the lenders to charge borrowers as little as 4.5% for 30-year loans. The U.S. Treasury will then buy mortgage backed securities with those loans in them. It will, of course, fund these purchases by selling Treasuries because we all know the U.S. government is running a giant deficit and doesn't have the money for this program just lying around somewhere.

The idea is to "play the spread" -- sell U.S. Treasuries yielding, say, 3% and buy MBS yielding, say, 4.5%. These newly subsidized loans would only be good for home buyers, not refinancers, and applicants would still have to meet the conventional loan qualifying standards set by Fannie and Freddie.

Forget for a minute the fact the release of this news now could just cause potential home buyers to hold off in the hope they'll get a lower rate later. Think instead about what this means for the U.S. longer term. We are talking about turning the U.S. Treasury into a giant hedge fund, or bank, if you want to be generous.

What I want to know is, won't this impact the perceived credit quality of U.S. debt obligations? Or the dollar for that matter? If we are acting like a bank/hedge fund, and selling hundreds of billions of dollars of debt to fund all these programs, shouldn't we be forced to pay up for money? There are early signs in the Credit Default Swap (CDS) market that investors are starting to ask themselves this very question.

Take a look at the chart above, which shows the cost (in basis points) of insuring 10-year U.S. sovereign debt against default. You can see it has risen to 65 bps from just 9.7 bps as recently as April -- meaning it costs about 65,000 euros (the contract is denominated in euros because, obviously, you don't want protection denominated in the currency of the country whose default you're insuring against) per 10,000,000 euros in U.S. debt.

Now I'll stipulate that this is peanuts compared to the cost of CDS insurance on many private credits (looking for GM protection? That'll be 6,915 bps please). And I'll aslo stipulate that bond prices have been flying this week, showing that RIGHT NOW, bond investors aren't selling into this news. But how long will this last? Can we really just keep borrowing like crazy, putting higher-risk securities onto the U.S.'s balance sheet, and have investors grin and bear it forever?

UPDATE: Fed Chairman Bernanke also just gave a speech suggesting other ways to restructure loans to avoid foreclosure, using goverment-provided subsidies. You can read the complete speech here.