Fannie, Freddie debt faces confidence crisis overseas

By Lynn Adler - analysis

NEW YORK (Reuters) - An extraordinary Treasury capital infusion may be needed to restore faltering foreign demand for debt issued by Fannie Mae and Freddie Mac, the two top home funding sources that the government is willing to rescue to save the housing market.

The companies rely heavily on overseas investment, often up to two-thirds of each new multibillion-dollar note offering, to help pare funding costs and keep mortgage rates low.

But foreign central banks have dumped nearly $11 billion from their record holdings of this debt in four weeks, to $975 billion, and won't return in force before it's clear if -- and how -- the government will back Fannie and Freddie, some analysts say.

President Bush has already approved the means by which Treasury and the Federal Reserve could bolster these two companies, which both reported greater-than-expected quarterly losses and steps to beef up capital.

Fannie (FNM.N) and Freddie (FRE.N) said they aren't seeking that support and Treasury Secretary Paulson said he isn't offering.

The bonds these companies issue in the $4.5 trillion agency MBS market are near or worse than the weakest levels, set in March before the government engineered the sale of failing Bear Stearns to JPMorgan.

"People are concerned about whether there's a bailout that's going to be coming from the U.S., so it would be logical to see foreign investors pull out of agency paper," said Kevin Chau, forex analyst at IDEAglobal in New York.

"They don't know whether the U.S. is going to be committed to supporting the GSEs, and if they are going to support them, by what methods are they going to support them."

A $30 BILLION SOLUTION?

Overseas investors took an atypical back seat in Fannie Mae's three-year note sale this week.

Central banks bought just 37 percent of the $3.5 billion issue, down from 56 percent in May's $4 billion offering of the same maturity. Asia accounts took just 22 percent of the notes, down from 42 percent in May.

Freddie Mac will soon also test overseas interest in the $3 trillion agency debenture sector. It announces August note funding plans on Monday.

"Most fixed income investors to whom we have spoken believe that a capital infusion by the government into Freddie and Fannie is a prerequisite for turning sentiment around in mortgage-backed securities and, by extension, in the broader fixed income markets," Barclays Capital analysts Rajiv Setia and Philip Ling wrote in a report.

A $10 billion to $15 billion infusion for each government-sponsored enterprise (GSE) is seen doing the trick.

"The longer the debate drags on, the more tentative foreign interest in the sector is likely to become. Even though the GSEs are adequately capitalized, investor confidence has been shaken," the analysts wrote. "A slowdown in international investor interest remains the major risk factor for agency spreads, in our view."