Paulson likely to reach for GSE "bazooka"

By David Lawder - analysis

WASHINGTON (Reuters) - U.S. Treasury Secretary Henry Paulson last month described a proposed federal backstop authority for Fannie Mae and Freddie Mac as a "bazooka" whose mere presence would silence market unrest over the viability of the two mortgage finance giants.

But just weeks after receiving the new weapon from Congress, the Treasury looks increasingly likely to have to use it, at a cost of billions of dollars to taxpayers.

A deepening American housing slump, mounting mortgage losses, and rising borrowing costs are conspiring to shatter confidence in Fannie (FNM.N) and Freddie (FRE.N), especially among their shareholders, who fear a de-facto government takeover will wipe them out. Shares of the two government-sponsored enterprises plunged to their lowest levels in 18 years on Wednesday.

"I think the number of options are dwindling every day that we see declines in the stocks. It has become virtually inevitable that the government has to nationalize Fannie and Freddie," said Kevin Cronin, chief investment officer at Boston-based Putnam Investments.

"For them to raise capital at these share prices would be so massively dilutive it would promote some serious lawsuits by shareholders," Cronin said.

The latest round of share price falls this week followed a Barron's article on Sunday that said the government may have no choice but to recapitalize the companies and news on Wednesday of a meeting between officials from the U.S. Treasury and Freddie Mac.

Sources familiar with the staff-level meeting said the two sides discussed the company's financial health and how it can best weather the current economic woes in light of moutninmountingg credit losses.

Freddie was forced to pay a record-high yield premium on a $3-billion debt sale on Tuesday -- 1.13 percentage points above Treasuries -- implying that foreign investors may be shying away from debt once seen nearly as safe as U.S. Treasury debt.

There is some disagreement among analysts whether Fannie and Freddie can squeeze through the next few months without government help. Key to their ability to do so will be yield spreads that Fannie and Freddie must pay to borrow funds.

"It seems to me that if spreads remain where they are, then ultimately, (the government) will have to put money into these entities," said Barclays Capital strategist Rajiv Setia said. "They have large amounts of debt that are rolling over in the next three months."

"MODEST INFUSION"

However, if the stock prices fall further, it could cause foreign investors and central banks to shun even the debt securities. He said a "modest infusion" of $15 billion for each of the companies in preferred stock would provide confidence in Fannie and Freddie and bring investors back, he said.

Bill Gross, Pimco Asset Management's chief investment officer, agreed, saying that ultimately the Treasury would buy $15 to $20 billion in preferred shares of each firm, though he does not believe a sale was imminent.

"Those purchases would require (government) funds, of course, and would count against the deficit," Gross told Reuters on Wednesday.

The federal deficit is forecast to more than double to $389 billion in the 2008 fiscal year needed September 30 from $163 billion the previous year. The White House anticipates a record $482 gap for fiscal 2009 as a weak economy saps tax revenues.