Fannie Mae, Freddie Mac debt soars on takeover talk

NEW YORK (Reuters) - Debt of Fannie Mae and Freddie Mac soared in their best one-day gain in history on Friday amid speculation that a government takeover of the housing giants would make the bonds more like ultra-safe U.S. Treasuries.

The prospects, sparked by deep consternation over the ability of the companies to survive on their own and a New York Times report saying the government is mulling a takeover, caused investors to flee the companies' stock, which some analysts said could be left worthless.

Investors were selling shares of the congressionally chartered companies and buying their debt, which if assumed by the government would be seen as safe as Treasury bonds, said Michael Kastner, head of fixed-income at Sterling Stamos Capital Management in New York.

Yield spreads on the corporate "federal agency" debt of the companies tightened as much as 29 basis points for five-year issues, according to broker GovPX/Garban-ICAP. The gapping eased to about 20 basis points, to 0.8 percentage point above Treasury notes, marking "unbelievable" shifts in a market that typically sees 1 to 2 basis point daily moves, a trader at a top-five bond dealer said in an e-mail.

It was the most extreme narrowing of yield spreads ever, UBS Securities said in a report.

"There's a closer linkage today with Fannie, Freddie and the U.S. government than ever before," said Jim DeMasi, chief fixed income strategist at Stifel Nicolaus & Co. in Baltimore. "It's a credit-quality upgrade."

But that also means a credit-quality downgrade for U.S. Treasury debt, which slumped, investors said.

The health of Fannie Mae and Freddie Mac is seen as synonymous with the U.S. housing market since they own or guarantee more than $5 trillion in mortgages. The companies hold charters from Congress to raise money from investors by purchasing home loans and pooling them into mortgage-backed securities. They also have massive investment portfolios of home loans and MBS.

Speculation that mounting losses at Fannie Mae and Freddie Mac would require billions of dollars in additional capital have fueled a firestorm of criticism this week, sending stock investors fleeing. Fear spread across financial markets after the government offered no hint that it would step in to help the companies.

The companies combined have about $1.6 trillion in debt outstanding, much of which is held by central banks around the world. They use the money to fund the portfolios and securities that lawmakers have increasingly relied on to support the ailing housing market.

Mortgage-backed securities issued by the companies also gained relative to Treasuries. But MBS issued by Ginnie Mae sharply lagged in price since their relative advantage of full government support over Fannie Mae and Freddie Mac issues would be diminished in a takeover.

Stocks of the companies dropped for a third day since investors do not expect a bailout would extend to shareholders. Both fell more than 40 percent when trading opened in New York on Friday, but clawed back after a key senator said the Federal Reserve may allow the companies to borrow directly from the central bank.

Investors also drubbed preferred shares of the companies, casting doubts that they would be able to raise the capital they need to avoid insolvency.

"The equity market and the preferred markets are telling you nobody wants any part of it," said Julian Mann, a mortgage and asset-backed bond manager at Los Angeles-based First Pacific Advisors.

Putting taxpayers on the hook for U.S. mortgages would upend the "entire free markets system," Mann said. "It's very disturbing."

After the 4 p.m. New York market close, Freddie Mac and Fannie Mae sought to dispel that they face capital shortfalls.

Freddie Mac said in a statement its second-quarter performance not yet announced reflects no immediate need to raise capital and that media speculation that it is on the threshold of conservatorship was not accurate. Chuck Greener, a Fannie Mae spokesman, said the company has ample liquidity and has the highest capital surplus in its history.

Agency debt already holds the highest ratings, but investors have demanded a nominal spread over Treasury debt for perceived credit risk. The spreads are less than for other publicly traded companies since investors see government ties representing an implicit guarantee.

Fannie Mae and Freddie Mac often pitched their debt in the late 1990s as an alternative to Treasuries, which were shrinking in supply due to a U.S. budget surplus. It coincided with the dawn of the housing boom and rapid growth in the portfolios under former Chief Executive Officer Franklin Raines.

(Additional reporting by Lynn Adler and Richard Leong; Editing by Dan Grebler)