A government rescue of Fannie Mae and Freddie Mac could be costly for scores of investment, banking and insurance companies that hold billions of dollars in preferred shares in the mortgage finance giants.
Speculation has been building on Wall Street that a government investment to rescue Fannie and Freddie would come in the form of a cash infusion through the acquisition of preferred shares in the companies.
Preferred shares usually pay a fixed dividend and have priority over common stock when it comes to dividends and bankruptcy liquidation. While slightly riskier than bonds, which have the highest priority in times of trouble, companies often invest in preferred shares for certain tax advantages.
Investors appear to believe existing common stockholders could be wiped out if there is a government bailout. Fannie and Freddie’s shares have lost more than 90 percent of their value this year.
But what happens to preferred stockholders is less certain.
“That depends on how big Fannie and Freddie blow up,” said Michael Shedlock, an investment adviser for SitkaPacific Capital Management.
On Wall Street, investors think it could be big. Fannie and Freddie’s existing preferred shares are trading like junk bonds: yielding around 17 percent to 19 percent instead around their 6 percent dividend levels. The higher yield is an inducement to investors to accept the higher level of risk that the companies won’t be able to pay their dividends.
“There’s enormous investor concern,” said Bert Ely, an Alexandria, Va. banking industry consultant.
Fannie Mae has 17 classes of preferred stock, with more than 600 million shares outstanding. Freddie Mac has 24 classes of preferred stock, with about 460 million shares outstanding.
Congressional analysts estimate a government rescue of the mortgage giants could cost taxpayers $25 billion, with the exact amount based on how far the U.S. housing market falls and how severe their financial situation turns out to be in the long run.
Another uncertainty is political: The final resolution of Fannie and Freddie’s future is likely to be determined after the Bush administration leaves office in January. It remains unclear how much in taxpayer resources the next administration and Congress would be willing to commit.
“The problem is: We’ve got questions. We don’t have answers,” said Hugh Johnson, chairman and chief investment officer of Johnson Illington Advisors in Albany N.Y.
The entire financial industry is trying to figure out what will happen to Fannie and Freddie because their stocks and bonds are so widely held, said Tony Plath, an associate professor of finance at the University of North Carolina at Charlotte.
“There’s not protection for shareholders of common or preferred shares,” he said.
But some believe that a rescue of Fannie and Freddie could be good for preferred shareholders.
“Even if (any) rescue effort gives a priority to the federal government...that still makes Fannie and Freddie more solvent,” said James Cox, a Duke University securities law professor. So, preferred shareholders could see the value of their investments rise, he explained.
Among the biggest holders of Fannie and Freddie’s preferred stock are U.S. insurance companies — a total of $4 billion worth, according to A.M. Best Co. Inc. But that still represents less than 1 percent of reserves the industry holds against losses.
“While some companies will probably have some writedowns, I don’t think there’s a widespread effect on the whole industry,” said Edward Keane, senior financial analyst with A.M. Best Co.
Fannie and Freddie together hold about half of U.S. mortgage debt and are the largest source of funding for home mortgages. But they are seeing too many of those mortgages go into default. Losses between April and June for the two companies totaled $3.1 billion, and investors fear the losses will continue to grow.
The Bush administration last month unveiled a plan to provide unlimited government loans to the two mortgage giants and to purchase stock in the two companies if needed for a period covering the next 18 months.
Investors believe that Treasury Secretary Henry Paulson is not interested in protecting common shareholders, only in Fannie and Freddie’s ability to support the battered mortgage market.
That means a government rescue might not occur until there is evidence the mortgage companies’ are unable to sell short-term debt — an indication they would no longer be able to operate normally.
On Thursday, Fannie Mae’s stock rebounded rising 45 cents, or 10.2 percent, to close at $4.85, while Freddie Mac fell 9 cents, or 2.8 percent, to $3.16.