August 20, 2008 / 2:53 PM / 10 years ago

Fannie, Freddie shares dive on bailout fears, bonds up

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.

A home that has been foreclosed and repossessed by the bank up for sale in Burbank, California, July 20, 2008. REUTERS/Fred Prouser

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.

Earlier this year, Freddie Mac committed to raising $5.5 billion in fresh capital to bolster its balance sheet, but investors are unlikely to buy new shares if they fear a government rescue might wipe out their equity.

Meanwhile, Fannie Mae Chief Executive Daniel Mudd, speaking Wednesday on National Public Radio, reiterated that the company has more capital than it has ever had, and that it has not asked, nor been offered, help from the U.S. Treasury.

Hedge-fund manager Doug Kass, who has placed big bets that Fannie Mae shares will fall, said on Wednesday that the depressed stock of the two companies will drop to zero, dismissing Mudd’s comments about its capital adequacy.

“What Mudd didn’t say is that the company is too leveraged to a depreciating asset — housing — and losses are off the charts and (there are) no signs of stability,” Kass, founder and president of Seabreeze Partners Management, said in an interview.

Fannie Mae and Freddie Mac own or guarantee almost half of all outstanding U.S. mortgages and the government is relying heavily on them to step up mortgage purchases to hold down home lending rates and help stabilize the flailing housing market.

It is important for Fannie and Freddie to keep operating, and recent government steps on their behalf were “appropriate,” Minneapolis Federal Reserve Bank President Gary Stern told Bloomberg TV on Wednesday.

But the looming U.S. election and the recent Congressional mandate to the Treasury to provide funding for Fannie and Freddie argue for delaying a bailout as long as possible, Bill Gross, chief investment officer of Pimco, said in an e-mail.

“That delay will only be possible if the GSEs continue to be able to sell discount notes and term debt at relatively stable spreads,” he said of the government-sponsored enterprises’ funding costs. If costs jump further and foreign investment fades, the Treasury will be forced to act sooner.

Foreign investment is being closely monitored, as ebbing demand means higher funding costs for Fannie and Freddie and thus rising home loan interest rates, analysts have said.

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Overseas central banks dumped nearly $11 billion of agency-related securities during the past month.

Russia, for one, is not planning to rapidly raise or cut exposure to debt issued by Fannie Mae and Freddie Mac, Russia’s deputy finance minister said on Wednesday.

Additional reporting by Patrick Rucker and David Lawder in Washington; Jonathan Stempel, Ellis Mnyandu, Jennifer Ablan and Anastasija Johnson in New York; Toni Vorobyova in Moscow;

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