GSE subordinated debt gains, preferreds lose

NEW YORK (Reuters) - The preferred stock and subordinated debt of Fannie Mae and Freddie Mac diverged sharply in price on Monday after the government drew a clear line in the sand between the securities that many investors thought carried similar risks.

The preferred shares lost more than 80 percent of their value after the government seized control of the two mortgage finance companies in a conservatorship on Sunday, creating a new class of senior preferreds for itself and eliminating dividends on outstanding issues indefinitely.

To the surprise of many, subordinated debt issues, meant to be indicators of the risks taken by the companies, emerged unscathed from the restructuring with their interest payments intact. Yield spread premiums on Fannie Mae subordinated debt maturing in 2011 plunged by three percentage points to a bid of 3.50 points, creating an instant windfall, with apparent momentum, for holders.

Investors over the past 24 hours have been scouring U.S. Treasury Department and Federal Housing Finance Agency comments for any sign that their preferred shares could see any recovery. But details from the Treasury suggest the companies will hold the dividends as long as the conservatorship lasts.

With a U.S. presidential election due in November, some investors wondered if there was a ray of hope for Fannie Mae and Freddie Mac who have used their power over the U.S. housing market to foster deep political ties. But the huge structural change underway at the government-sponsored enterprises (GSEs) will be hard to stop, analysts said.

"Once we crossed the rubicon of doing what Treasury and FHFA have done, it would take something substantial for the new administration to reverse some of this," Scott Peng, a rate strategist at Citigroup said on a conference call on Monday.

Peng said that Citigroup did not expect the move by Treasury, and that there was no sense of urgency. Citi equity analyst Bradley Ball was one of many Wall Street analysts in recent weeks that said the companies had enough capital to operate at least into 2009.

INVESTORS FLUMMOXED

Investors felt blindsided by the Treasury's move after participating in Fannie Mae's sale of $4.25 billion in convertible and non-convertible preferred issues just four months ago.

The Bush administration since late 2007 had encouraged Fannie Mae and Freddie Mac to raise capital as the mortgage finance giants began to report heavy losses due to the housing slump, and predicted more to come. Both saw preferred issues as a good option.

"The problem with eliminating the dividend is the government told these guys to get more capital and the people who just invested in that capital were told, 'no dividend,'" said Andrew Harding, head of taxable bonds at Allegiant Asset Management in Cleveland, Ohio.

"It's not like someone held a gun to people's head to buy this stuff, but (the government) told Fannie and Freddie to get more capital," he added.

Two recently issued preferred shares from Fannie Mae and Freddie Mac, which were priced at $25, are now trading below $3 on the New York Stock Exchange.

JPMorgan Chase & Co warned late last month that the market value of its investments in Fannie and Freddie preferred stock dropped by half to $600 million this quarter, and the decline will affect its earnings.

Investment bank Keefe, Bruyette & Woods published research last month warning that while large-capitalization banks do not hold much of the government-sponsored enterprises' preferred shares, regional banks including Gateway Financial Holdings, Midwest Banc Holdings and Sovereign Bancorp Inc have significant exposure.

Meantime, securities meant to bear risk of company failure gained along with the senior debt, whose fate in a bailout was never questioned. For details, see:

But the previous GSE regulator, the Office of Federal Housing Enterprise Oversight, as recently as 2007 found subordinated debt wasn't doing its job. Like in the senior "agency" debt, investors perceived an implicit backing on the subordinated debt, which "contributed little to market discipline" of the companies, an OFHEO report said.

An article in the business newspaper Barron's in mid-August suggesting subordinated debt would suffer losses in a bailout sent the bonds tumbling, leading investors, including Jamie Jackson of RiverSource Investments in Minneapolis, to buy.

The bet was "mostly based on a re-reading and a verification of what's in the prospectus," he said. "There are contract laws. Fannie Mae or Freddie Mac doesn't have the right to just not pay a coupon on the subordinated debt."

Standard & Poor's late last month also downgraded the subordinated debt of Fannie Mae and Freddie Mac on concern that interest payments could be deferred due to events that affect the companies regulatory capital. After the takeover, S&P on Sunday boosted its outlook on the subordinated debt.

(Additional reporting by Richard Leong and Lynn Adler; editing by Clive McKeef, Gary Crosse;)