Fannie and Freddie risk preferred share downgrades

NEW YORK (Reuters) - The subordinated debt and preferred shares of mortgage finance companies Freddie Mac (FRE.N) and Fannie Mae (FNM.N) may be downgraded if additional losses from bad mortgage loans depress earnings more than anticipated.

Any downgrades would make raising capital more costly at an inopportune time as the government-sponsored enterprises (GSEs) replenish regulatory capital levels to cover mortgage losses and expand their respective mortgage portfolios.

"The ratings of the GSEs' subordinated notes and preferred stock could be at risk, given the likelihood of weak earnings over the next year," said Ira Jersey, U.S. interest rate strategist at Credit Suisse in New York.

Fannie Mae and Freddie Mac, which have lost around $12 billion combined in the past year, are expected to report second-quarter earnings next month. Credit ratings agencies have warned that if mortgage losses exceed company estimates then a rating cut is possible.

Standard & Poor's said in May that if credit losses for 2008 exceed Freddie Mac's projection of 16 basis points of its portfolio, or Fannie Mae's forecast of 13 to 17 basis points, and lead to higher than expected operating losses, their subordinated debt and preferred stock ratings may be cut one notch.

Moody's Investors Service said in May that if higher mortgage losses deplete Fannie and Freddie's capital, it could breach a regulatory threshold and result in the preferred shares of both companies being downgraded, though it added they are expected to take steps to ensure capital cushions.

Fannie and Freddie are near ratings agency thresholds for the amount of preferred securities they can hold as a percentage of regulatory capital.

"The preferred shares are particularly at risk of a downgrade, as preferreds as a percentage of regulatory capital is already near the 40 percent maximum that rating agencies like them to hold," Jersey said.

"About $2 billion in losses at either Freddie or Fannie would put preferred shares over the 40 percent threshold and would pressure ratings downward," he said. "Then further common equity issuance would be necessary to keep those ratings stable."

PRICING PRESSURE

Freddie Mac said in May it plans to raise $5.5 billion. Fannie Mae raised $2 billion in May in a sale of preferred stock after posting a first-quarter loss, and analysts expect it will need to raise more.

The cost of raising this capital, however, can jump suddenly, as evidenced by plunging share prices and rising debt yields on Monday.

The move, caused by jitters over the amount of capital the companies would need to raise, largely reversed on Tuesday though levels remain significantly weaker than in early May.

Fannie Mae's share price has dropped to $18, from around $30 in May, while Freddie Mac's shares have dropped to $13 from the $26 area in the same period.

The cost to insure both companies' subordinated debt with credit default swaps has more than doubled to 196 basis points, from the 90 basis points area at the beginning of May, according to Markit Intraday.

Continuing uncertainty over earnings and capital raising is likely to further pressure Fannie Mae and Freddie Mac's debt securities, while a downgrade of its subordinated debt is probably not yet fully baked into its credit default swaps.

"Monday's price action is more illustrative of the continued concern around financials' ability to raise capital, with the number of institutions needing capital seemingly growing while the number accessing new capital is slim," analysts at Barclays Capital said in a report on Tuesday.

"Along with second-quarter earnings concerns, we expect investor risk aversion to remain elevated in the near term and we remain cautious barring new data points," they said.

"Part of the risk of a downgrade has already been priced into the credit default swaps on the subordinated debt but there will probably be a little but more weakness in subordinated notes if they are actually downgraded," said Credit Suisse's Jersey.

Fannie and Freddie's senior debt could also continue to weaken, in spite of the implicit guarantee the government provides to the top-rated debt.

"Arguably there is an unquantifiable, implicit federal tie to the GSEs, but increasing credit costs and capital needs would likely still further pressure securities prices," said Christopher Sullivan, chief investment officer for the United Nations employees' federal credit union in New York.

(Additional reporting by Al Yoon and Anastasija Johnson; editing by Gary Crosse)