Fannie, Freddie shares dive on bailout fears, bonds up

By Lynn Adler

NEW YORK (Reuters) - Fannie Mae and Freddie Mac shares plunged to their lowest levels in almost 20 years on Wednesday, while the mortgage companies' bonds rallied on the belief that an increasingly likely government bailout would wipe out shareholders but secure their massive debt.

U.S. Treasury and Freddie Mac officials met to discuss how the company can best weather the current economic woes in light of mounting credit losses, sources familiar with the meeting said, but neither Treasury nor Freddie Mac officials would comment on details.

"As you would expect, we have been in communication with the companies for months to receive updates and we've been communicating with their regulator and the Federal Reserve," Treasury spokeswoman Jennifer Zuccarelli said.

Wednesday's meeting was one of several since mid-July when the U.S. Congress approved a plan to provide any necessary extra funding for both Fannie Mae and Freddie Mac.

Anxiety about the companies has risen this week following a report in Barron's newspaper that government officials may have no choice but to go ahead and effectively nationalize Fannie and Freddie as rising defaults on home mortgages undermine the value of their assets.

Freddie Mac's stock slumped 22 percent to $3.25, after falling to the lowest level since 1990, and Fannie Mae shares slid nearly 27 percent to $4.40, after hitting the lowest level since 1988.

"We continue to be concerned about what dilution would be required to stabilize Fannie and Freddie, and what that would leave over for existing shareholders," said Marshall Front, chairman of investment firm Front Barnett Associates in Chicago.

But the debt of Fannie Mae and Freddie Mac rallied, as bond investors believe the government will do whatever it takes to maintain confidence in the two companies, since their ability to issue debt, and use the proceeds to help fund U.S. home buyers, is critical to pulling U.S. housing out of its worst slump since the Great Depression.

CreditSights analysts said in a report that it was a "highly remote" possibility that senior debt would be impaired in a government investment in the U.S. mortgage giants.

While the Treasury is going to try to avoid nationalization, other rescue scenarios include the Treasury buying the agencies' mortgage-backed securities, or other debt, or preferred shares, according to Ira Jersey, U.S. interest rate strategist at Credit Suisse in New York.

"(It could be) something like a convertible preferred deal that might end up diluting shareholders, but at the same time the rest of the capital structure winds up doing OK," Jersey said.

Fears that the two companies will need to be bailed out forced Freddie Mac to pay record-high yield premiums on a $3 billion debt sale on Tuesday.

But Freddie Mac's debt prices rallied on Wednesday and the yield gap over Treasuries was sliced to about 0.98 percentage point from 1.13 points a day ago, even though U.S. Treasury bonds also rallied.

"It's fundamentally a flight to quality," said Lee Olver, fixed-income strategist at SMH Capital in Houston. "The market sees that takeover as further illustrating the guarantee of the government," Olver said.

The cost to insure Freddie Mac senior debt against a default with credit default swaps fell 18 percent to 40 basis points, or $40,000 a year to insure $10 million of debt for five years, according to Markit Intraday. Fannie's spreads also tightened about 16 percent to 40 basis points.