Real estate geeks should read this whole long interview with mortgage fund manager Jeffrey Gundlach.

Could you elaborate on the subsidy these agencies are providing?

If Fannie Mae [ticker: FNM] and Freddie Mac [FRE] stopped all of their activity — for a moment, forget about shutting them down and being insolvent — in order to sell off mortgages as normal loans without this guarantee, the interest rate would have to be around 9% or 10%.

So the government, by buying Fannie Mae and Freddie Mac securities, is essentially providing money for the market at about 5%. They are subsidizing the interest rate that the private-capital markets would require by about 400 or 500 basis points [four or five percentage points]. That helps finance the housing market. Loans will be available at a subsidized rate, and that will help to cushion the blow, over the medium term, for the housing market.

Who benefits and who loses out from this bailout?

It is a moderate positive for the housing market over the intermediate term, and it is a modest positive for the consumer economy over the short term. But none of these is a major positive. It is not going to reverse the consumer’s distress entirely, and it is not going to stop housing prices from falling between now and year end.

What other negatives do you see?

Inflation risk down the line. [The federal government is] going to probably overstimulate and over support in an attempt to stem these deflationary forces. We are looking at a longer-term inflationary force that is pretty substantial. This has been my view for a long time. Interest rates went into a very long decline from the late ’70s and early ’80s until earlier this decade, when first we saw rates bottom out. Then rates went up a couple of times.

Basically, we are getting back down toward those low levels again. The multiyear bottom in interest rates that started around 2002 will probably last into 2009. Then we are going to see the inflationary aftermath of these government policies, and you might be surprised at how high interest rates go.

Another explanation of a possible upcoming “sweet spot” for home buyers, that point when home prices AND interest rates are both low.

Where else does this rescue effort come up short?

The government can subsidize the interest rate for mortgages, and I suppose that is going to help some. But it is not going to change the person who basically doesn’t want to pay the loan back because since the loan now exceeds the value of the house, they are going to own this big loss if they pay the loan back. So the only solution for those people would be a big modification in which some of the principal gets written down. Then maybe they wouldn’t default.

But let’s face it: A lot of people don’t know about modifying the terms of their mortgage or don’t know how to pursue it, and the system is log-jammed anyway.

So homeowners tend to bail out when the mortgage is higher than the home value and government programs can’t do much about that.

How much more pain are we going to feel in the housing market before things start to stabilize?

I think we are about half way through. There is high momentum in terms of home-price declines, so it is pretty clear they are going lower. It always looks a lot like the hills on a roller coaster. It starts out with a flattish period. Then it starts to go down, and then it really starts to drop, and we are clearly in that period. That period is going to be with us for about another year before it flattens out and bumps along in 2010.

The S&P/Case-Shiller Index is down a little more than 15% from its peak in 2006, and I’ve believed for some time that the index will have dropped 30% from its peak. That means some markets are going to drop by 50%. That includes Miami, Las Vegas and Phoenix, all of which were fueled by subprime lending. The foreclosure overhang is so big in those areas.

I don’t know if Phoenix overall will see a 50% decline, although we’ll see some zip codes hit that.

What else has to happen? More housing inventory has to get worked off?

Exactly. Everything is supply and demand. Unfortunately, the fundamentals of supply, with the foreclosure overhang being a very important part of that, are really discouraging. Supply is at its highs. This bailout by the feds helps liquidity, but it is on the margin. And the fundamental problem of liquidity is not getting any better.

Could you elaborate?

First it was hedge funds that couldn’t use any more leverage. And now the banks are taking write-downs, so there is less money that can be lent. Now, I hear over and over from the largest investment pools in the world that they are cash-constrained. I just had a meeting with one of the biggest endowments in the United States. They said that for them to invest in something they have to sell something. I often hear people saying, ‘We love thinking about distressed-mortgage opportunities because they sure are cheap, but we don’t have any money to invest.’

Since lenders don’t have a lot of money to lend, they tighten their lending criteria and only make very safe mortgages which leads to an excellent return on their money.

What’s ahead for mortgages?

The agency-guaranteed mortgages have been spectacular, performing strongly this year. Most people wouldn’t believe that, because you think anything but that would have to be true.

Does that include mortgages backed by Fannie and Freddie?

Yes, it does. Fannie, Freddie and Ginnie Mae mortgages altogether are up more than 5% year to date. The stock market is down 15%, and these securities are up 5%; Treasuries are up even less.

Mortgages that are guaranteed are the top performer, mainly because they have paid all of their interest and they have a guaranteed principal payback, thanks to Uncle Sam.

“Spectacular” Wow!

How much difficulty will we have to go through, with mortgage rates resetting?

Very little. One of the greatest misconceptions now is reset risk. Reset risk was very real on subprime, because the teaser rates were very low compared to what the ultimate rate is, usually like 600 or 800 basis points over Libor [the London interbank offered rate]. With today’s Libor at 2.50%, the reset rates can go to 8% or 9%. But most of the subprime mortgages reset after two years, and all of the subprime resets are going to be over by the end of this year.

Good to know! “… all of the subprime resets are going to be over by the end of this year.”

Of course, it will take months for those last resets to work their way through until they hit the foreclosure market but at least the real estate market will be looking at a tapering off of the reset effect on the supply of bank owned homes.

What about for prime loans and Alt-A loans, which are between prime and subprime?

The reset problem really isn’t a problem, thanks to the Fed having engineered the fed-funds rate down to 2%. These loans typically reset off of Libor or T-bills, plus no more than 3%. So when they do reset, it’s going to be at a lower rate, or at about the same rate that the homeowner is paying now, in many cases.

This is good news. I suspect the prices in some areas of metro Phoenix will start bottoming out at the end of the year. However, I was worried about the impact of the upcoming Alt-A resets, especially that graph showing the huge size of future Alt-A resets.

At the Morningstar conference in June of last year, you called subprime “an unmitigated disaster” that would get worse. What’s your assessment today?

It is unmitigated disaster times 10; subprime continues to get worse in terms of delinquencies and defaults, which are worse every month.

Will delinquencies and defaults from this point forward surprise on the upside? I doubt it, because the market has accepted the idea that subprime defaults are going to be up at about 50% of the original volume.

When you look at subprime lending patterns, the defaults really spike for loans underwritten in 2006.

It is like somebody flipped a switch right around the second half of ’05, and the world went crazy. You can see it all in the volume of structured-finance vehicles, including CDOs [collateralized debt obligations] and SIVs [structured investment vehicles], and in the underwriting standards, which went to hell. The gap between the origination point and risk-taker point, where the loans were actually held, got wider and wider.

It was clear in the summer of 2005 that the market had peaked. I never quite figured out why prices continued to climb for another year.

It turns out it was because the mortgage world “went crazy” and they continued to pump more and more money into residential real estate.